This article appeared in the April 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
How the market's Big Four stocks stack up on this value investor's radar.
By Paul Zwi, Clime
The recent sharemarket rally is all about the expansion of price-earnings (PE) multiples. Corporate earnings across the market have barely lifted, so investors have re-evaluated earnings forecasts and are prepared to pay a higher PE multiple than six months ago for similar expected earnings.
In intrinsic value terminology, the higher market prices reflect investors accepting a "lower required return", and their appetite for shares is being stimulated by lower yields on offer in term deposits.
Although corporate earnings in the US have exceeded pre-GFC levels, hence US sharemarket indexes are touching new highs; earnings in Australia have barely grown above 2008 levels - a period of rapid earnings growth that was stimulated by a build-up in household debt.
Three key factors differentiate our sharemarket from the US:
- The high Australian dollar acts as a headwind to ASX-listed corporate earnings.
- Relatively high interest rates. Even after a series of official rate cuts, at 3 per cent our short-term rates are well above the US, especially when combined with its quantitative easing programs.
- Weaker commodity prices, which have an outsized impact on our market because of the composition of our index.
The corporate bellwethers
Four stocks widely held across Australia offer differing insights into the economy and the investment environment: Telstra, Commonwealth Bank, Woolworths and BHP Billiton.
Combined, they account for around $328 billion in market capitalisation and 32 per cent of the S&P/ASX 200 index. By contrast, the top 10 largest holdings in the US S&P 500 make up only 18.6 per cent of that index. Here is an overview of Clime's assessment of the four stocks.
(Editor's note: Do not read the ideas below as stock recommendations. Do further research of your own or talk to your financial advisers before acting on themes in this article.)
Telstra has been a top-performing share over the past six months, as indicated by its price appreciation and dividends, and has outperformed the rest of the market.
The key to Telstra's re-rating has been the combination of a sustainably high dividend yield coupled with a business that is far better managed than it used to be. Telstra will maintain a 28-cent fully franked dividend for the year, which provides a healthy yield of 6 per cent at current share prices, a major factor driving its appeal to retail sharemarket investors, particularly retirees.
In its most recent results, Telstra showed how it has managed to reduce debt while maintaining spending on necessities. In the past six months, Telstra has:
- Signed up 670,000 new mobile customers
- Signed up 85,000 new fixed broadband customers
- Sold about 500,000 iPhones
- Upgraded 2000 sites to 480,000 customers to access ADSL2.
Telstra is justifiably confident about its outlook. The rollout of 4G, or the Long Term Evolution (LTE) network, involves substantial cash expenditure before cash comes in from phone sales and pre-paid and monthly contracts. You have to spend money to make money, but once the money has been spent the return on investment should follow swiftly.
Telstra has been funding its build-up for the 4G rollout entirely on its own. None of the $11 billion allotted for the National Broadband Network made its way into the company's coffers in the last half.
For yield-driven investors, Telstra remains a hold at around current levels of $4.50, in Clime's view, but has been trading well above our valuation for some time. This probably acknowledges the bond-like characteristics of Telstra, with its solid yield.
It is worth holding, but remember that when interest rate markets normalise in due course, the "yield compression" strategy that has captured investor attention over the past year might quickly reverse; that is, higher bank term deposit rates and a lower yield on Telstra could reduce its relative attractiveness.
Woolworths delivered sound first-half results, with sales from continuing operations up 4.8 per cent to $30 billion and profit from continuing operations, before significant items, up 5.5 per cent to $1.25 billion. Statutory profit after tax was up 19.4 per cent to $1.15 billion.
Australian food, liquor and petrol were again the primary drivers of the result, with segment earnings before interest and tax (EBIT), before significant items, up 6 per cent to $1.65 billion in the half. The NZ supermarkets, BIG W and Hotels segments delivered EBIT growth of 5.2 per cent, 8.3 per cent and 21.2 per cent respectively.
Central overheads and the Masters home improvements chain produced a loss at the EBIT line, largely reflecting the current sub-scale position of Masters. Its rollout continues with 25 stores trading at the end of the half year, an increase of 10 since June 2012. Management expects to have "at least 30 open at the end of FY13" and the target is 100 by the end of 2016.
Although in the near term this upfront investment is a drag on profit and profitability, Clime remains optimistic about its longer-term potential. Sales were up 54.6 per cent during the half to $637 million.
During the half, Woolworths created a new ASX-listed real estate investment trust, SCA Property Group (ASX: SCP) through an in-specie distribution of stapled units to all Woolworths shareholders. The sale of 69 neighbourhood and sub-regional shopping centres and freestanding retail assets to SCP, which were valued at $1.4 billion, reduced the quantum of property on the balance sheet.
This in turn released capital to enable management to focus on the company's core retail business. In our view, this was an intelligent move that should see longer-term benefits in profitability, ultimately increasing value for shareholders.
We rate Woolworths highly as a business dominant in its sector, well run, with a strong balance sheet, and predictable and sustainable revenue and earnings. We note the business has enjoyed a strong normalised return on equity (NROE) over the past five years of 33 per cent, and expect this to continue at similar levels.
On the other hand, the share price has run strongly and at March 20 was trading in line with our 2014 valuation of around $34, providing little opportunity for value investors to buy at a discount. Woolies is worth holding for long-term growth.
3. Commonwealth Bank
CBA announced revenue increased 5 per cent; expenses increased 3 per cent and net profit after tax (NPAT) increased 1 per cent to $3.66 billion for the half year. The net interest margin (NIM) increased four basis points over the half, driven by lower funding costs. (Net interest margin is the difference between interest that banks generate, and interest paid out to lenders).
Over the year, NIM declined by a small two basis points, which bodes well for sector profitability after a prolonged period of NIM compression.
CBA announced Tier 1 capital of 10.6 per cent, up 130 basis points over the previous corresponding period, and indicates that CBA is well capitalised. Should credit growth remain subdued, there is the possibility of increased dividends or perhaps a one-off special dividend.
In further good news, CBA continues to lead peers on the number of products per customer (2.9). It is also the most exposed to sharemarket movements, through its growing wealth management business, Colonial First State (CFS). Over the half, CFS funds had their highest net inflows for the past five years.
The cost-to-income ratio declined 70 basis points on the previous period, highlighting the focus on costs in a low credit growth environment. CBA enjoys the largest share of the local home-loans market with 25.1 per cent (up from 18.7 per cent in June 2007) and has increased deposit funding by 8 per cent over the year. Deposits contribute 63 per cent of CBA's total funding requirement, a significant improvement since before the GFC.
Bad debt expense increased four basis points over the six months to 0.32 per cent of gross loans. Longer-term impairments have continued to trend down. Impaired assets to gross loans and acceptances are the lowest of the big banks at 0.79 per cent. CBA announced a $1.64 fully franked dividend for the full half-year, up significantly, but noted that a marginally reduced final dividend was likely.
CBA is an attractive company with the highest return on equity of the big banks, while having probably the lowest risk in the sector. Its average normalised return on equity of 23 per cent over the past five years is well in excess of most international banks and ahead of its domestic peers. We rate CBA a long-term hold, but every stock has its price and it is a mistake to fall in love with a listed security, even an excellent one. Above $77 per share, we would think carefully about crystallising some capital gain.
4. BHP Billiton
BHP Billiton, like all the big diversified miners, is recalibrating its strategy to contend with declining commodity prices following waning global growth. In its most recent half-year report, BHP experienced a drop in earnings and announced asset sales of $4.3 billion. In the past year it has put projects on hold estimated to cost around $68 billion.
When it released its results on February 20 it unveiled underlying earnings before interest and tax (EBIT) was down 38 per cent to US$9.8 billion, and $1.9 billion in cost savings.
Net operating cash flows were down 48 per cent, with the effect of the decline in the iron ore price particularly severe despite strong volume growth. BHP said a slowdown in demand for minerals over the next five years made cutting costs and boosting productivity priorities.
Incoming chief executive Andrew Mackenzie, who takes over from Marius Kloppers in May, spoke about productivity in an environment where China's demand for minerals will remain strong.
But strong growth is relative. The likelihood is the growth rate will fall from the heady 15-20 per cent per annum over recent years to around 2-4 per cent in future years. That means a focus on being low cost becomes imperative.
In such an environment, Mackenzie said, there is appetite for "only the best projects so we … get some of the highest capital productivity". The price of iron ore, one of BHP's most profitable divisions, averaged 27 per cent lower during the six months to the end of 2012. Prices remain volatile and recently fell by around $20/tonne, from $150/t to $130/t, and could fall further. BHP disclosed its sensitivity to the price: a US$1/t increase equals FY13 net profit after tax of about US$110 million.
Shale gas is an area of particular opportunity for BHP in the next few years and provides a clear differentiation from some of the other major diversified miners, such as Rio Tinto. BHP is spending $4 billion this year on its US shale gas assets after acquiring them for $20 billion in 2011. The US is experiencing a shale oil and gas bonanza, and despite booking a $2.8 billion charge last August on the value of the assets, the long-term potential is promising.
Despite short-term volatility, management anticipates a modest improvement in global growth, which bodes well for commodities demand. The longer-term outlook for copper appears favourable as anticipated demand strongly outpaces supply growth.
As one of the very few Australian companies that are global leaders in their sector, BHP remains a core holding for diversified portfolios. It is trading at a discount of around 13 per cent to Clime's $39.18 valuation.
About the author
Paul Zwi, is director, private clients, of Clime Asset Management, which manages Clime Australian Value Fund, one of the top-performing Australian retail funds over one, three and five year. For further information, contact: Paul Zwi or John Abernethy. All prices at March 20.
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