2013 is shaping up as another pivotal year for markets following a 'tiresome' 2012 that saw some extreme volatility mid year, culminate in a positive Q4 performance. All in all, the ASX 200 added +14.5% - a result that probably sugar coated some of the complexities that investors had to deal with throughout the year.  

 

That said, the mkt is now in a better place and prospects for 2013 seem positive, even though we'll probably still be reading and hearing about the same old macroeconomic headwinds and challenges in the year ahead.

 

At a macro level, Chinese growth is likely to pick up strength post the once in a decade change of leadership which takes place at the National Peoples Congress in March. Most estimates I read have China growing back up above 8% in 2013 which is clearly good for us, and the global economy more generally. 

 

One of the main risks I can see in China is inflation but that's unlikely to become a problem until 2014 or beyond. After the inflationary impacts of their GFC support package, they're clearly reluctant to stoke up prices, particularly in some areas of their economy such as housing. This time last year I wrote..,.

 

One question that does trouble me a little is the challenge facing an economy that is hot in some parts and cooling in others. Yes, the Government has the tools available to re inflate prices if things start to come back too hard but how they support some parts whilst dampening others will be critical.  

 

Property prices for instance are still at elevated levels and the government wants to avoid a bubble, yet they want to continue to support manufacturing given the slowing demand coming out of Europe. An interesting conundrum! 

 

As is stands, they've done pretty well so far. They've cut interest rates across the board but only by about 55bp. They've reduced the Reserve Requirement Ratio for some banks -  targeting the lenders that support smaller, local manufacturers. They also increased the flexibility within the banking system so loan rates (and savings rates) can be somewhat massaged depending on individual circumstances. 

 

In essence, they seem to realise that their economy has many dynamic parts and that one size doesn't fit all. In 2013, infrastructure spend will be one of the biggest supporting factors for growth.   

 

The US should see some better growth numbers too, given the private sector deleveraging process is more or less complete. Corporate America has remained fairly strong albeit with obvious nervousness (hence the lack of hiring). Once they start to see consumers spending again, and SME's investing, the big Corporates are likely to follow.

   

The situation is not as positive in Europe or Japan where we continue to expect ongoing struggles. I'm sick of talking about Europe and promised myself I'd do less of it in 2013, however one quick comment must be focused on the ECB and their actions in 2012. 

 

At the start of last year we wrote.... 

 

The market can't have a sustained rally until we see that these nations can refinance debt and it seems that it will take some type of involvement by the ECB to provide the confidence needed in the market, which in turn will put downward pressure on bond yields. 

 

The ECB came to the party mid way through last year and in my mind, that was the turning point for the region.  

 

In Australia, the economy is actually showing signs of fatigue, and a likely up tick in unemployment as well as continued issues with consumer and business confidence should see the RBA remain active, and we expect cash rates to be 2.5% by mid year. (NAB expect 2.25% and ANZ are at 2%). This will be the most influential theme for domestic markets in 2013. 

 

One of the biggest calls by the RBA last year was the prediction that the mining investment boom would peak lower, and end sooner than they had originally thought. They're now calling a peak at the end of 2013 and are feeling an obvious need to help stimulate other sectors, - in the hope they'll take up the slack. 

 

I'm not as sure as the RBA that investment will peak this year. One economist I find insightful is Adam Carr. He treads his own path and often contradicts main stream thinking - I like that.

 

He recently wrote....According to estimates last week, still $268 billion in committed investment projects - an upgrade from previous estimates and over three-times the amount of mining investment completed over the last year. That was itself a record. Have a look at chart 2 (from the Bureau of Resource Economics) as a reminder.

 

One of the main aspects he sights in other articles is the massive investment in LNG. Although we might be seeing investment in more traditional mining businesses such as Copper and Iron Ore taper off, the massive amount of development in gas is more than enough to keep the boom going.  

Current Market Stats

  

 

Currently, the ASX sits at 13.1 times forward earnings, which remains on the 'cheap side' of historical averages. 

 

 

We also see collective Dividend Yields around 5% and when adding in franking credits, and the expectations towards cash rates, it adds to the appeal. Also important to note, that's a stat that covers the entire mkt - a lot of the portfolio's we run are yielding 7% or more, then add franking on top. 

 

 

Dividend yields also compare favourably to Bond yields. 

 

 

Although the market remains somewhat undervalued based on historical multiples, we have seen a recent rally in stock prices which has been on the basis of PE expansion rather than growth in earnings. 

 

That's not necessarily a reason to be alarmed yet, as bullish phases 

pre-empt earnings growth - however it's growth in earnings that support sustained moves higher. So we do need to see some signs of earnings optimism by Q2 at the latest.  

 

 

Here's another take on mkt PE's which is a more dynamic way of viewing its relationship with different periods within the cycle.  

 

Market outlook

 

I expect the ASX 200 to be above 5000 by year end. This is built somewhat on the improving macro backdrop, but more so on the impact of domestic monetary policy which I think will;

 

1.Reduce the appeal of alternative assets (mostly cash), and

2.Ultimately bring down the AUD towards 90c which, although is still high from a historical context, would be at a level that wouldn't pose too much of a headwind for business. 

 

I think the second point there is the contentious one. I've been looking for the AUD to come back for the past few months but it just hasn't despite the tightening interest rate differential between us, the US & Europe.  

 

One of the main impacts the Dollar has from an equity markets point of view is the attractiveness or otherwise of our mkt to overseas funds. If our market falls, the AUD is likely to fall as well, making it even cheaper. If we rally, the AUD is also likely to move higher making it even more expensive. 

 

So, because of these factors, I think any weakness (3-5%) in our mkt will be bought into, while its hard to see our mkt really kicking into gear given the impact of the currency. That's one of the reasons why our target is around the 5000 level by year end - and not higher.   

 

That said, if we do see any type of Central Bank intervention in our currency mkts, where the RBA offer up some of their currency reserves , which prompts weakness in the AUD, that's likely to be the catalyst for the mkt to really kick into gear. In my mind, that's the time to go a lot heavier into equities and it should be the start of the next real bullish phase in the market (not just a bear mkt rally). 

 

I know this is an optimistic call and it will be met with some decent skepticism however its harder to argue with charts. We've had 12 years of a secular bear market - history shows they generally last about 9.4 years in the post world war two era. 

 

So, if we have any faith in past experience, we've got to be conscious that at some point, probably soon, we will come out of this broad range trading environment and head into an upward bias. 

 

A few observations

 

1. Stock markets don't necessarily track underlying economic performance

 

This has been particularly obvious with the strong stock mkt performances in Europe and the US, where economies remain relatively weak.  Contrast this with China, where the economy is strong, stocks only added +3% in 2012 . This theme has also been obvious in Australia over the past few years where our stock market has under performed other developed economies despite our underlying economic metrics showing relative strength. 

 

So, economic strength or otherwise doesn't necessarily have a high correlation to market performance, and mkts can indeed overcome economic headwinds. What really counts is the policy being rolled out by Central Banks and Governments. China had a tightening bias throughout 2011/2012, but it now seems they're more likely to start easing again. In Australia, our Central Bank was sluggish to react to global issues and we had relatively tight monetary policy - now the RBA is clearly in an easing mode. 

 

 

2. Political incompetence is being increasingly tolerated

by mkts and even though we'll continue to see Republican's & Democrat's - Labor and Liberal's, dominate headlines, we're unlikely to see the mkt react as violently to politicly driven news flow as we saw in 2011/12. 

 

On the domestic front, we've got an election coming up this year and the current Govt finds itself in a toxic position, helped only by the considerable doubts about the Oppositions ability to manage the treasury benches, not to mention their inability to put forward anything that borders on constructive policy. 

 

It may sound harsh, but this lack of faith in either political party renders them both liabilities to economic growth and I've little confidence in either Gillard or Abbott as our PM...(surely the Libs have a better candidate...?). Anyway, one positive coming from this years election could be the fate of the Independent's, who have held way too much power in the parliament since the compromised Govt took office. 

 

 

3. Market information & commentary is instant, and the ease that sometimes uneducated opinion finds an audience has made it increasingly confusing for investors to decipher what's valid and what's not. With so much noise, contrasting opinion, real time updates and sensationalism from some parts of the media, its been hard to maintain clarity of thought - that theme unfortunately is one that will continue and expand in the years ahead. 

 

Although information is good and knowledge is power etc, I think at times it can be counter productive when we're in the business of making medium to longer term investment decisions. I think this year, more than most, it will be important to understand the macro backdrop, but not get caught up in its noise. Instead, focus attention more towards analysing sound investments.  

 

The concept of yield support - a big theme in 2012 that is set to continue

 

This concept has built momentum over the past 12 months, and is likely to continue into the first half of 2013 at least. Cash rates have come back from 4.75% at the end of 2011 to 3.00% now and if we reach our estimated level of 2.5% by mid this year, that would equate to a fall of 2.25% - or in other words, if you've got a $1m sitting in the bank earning the cash rate, instead of getting $47,500 pa, you'll get $25,000 pa. 

 

In contrast, a diversified portfolio of shares and fixed interest securities can yield more than 7% plus franking. Granted, there will be some capital volatility however the return differential is quite significant. 

 

I suspect this is a conversation that will be had by many of the 910,000 Self Managed Super Fund Trustees now in Australia, that control about 30% of the $1.4 trillion in superannuation funds domestically. That figure collectively has risen by  $117.5 billion - the second-highest figure on record -  in the year to June 30. 

 

Looking at the bank funding mix, it shows a lot of new money has gone into term deposits, attracted by high interest rates and pretty aggressive deals by banks & building societies as they diversified their sources of funding, away from more volatile International debt mkts, to domestic deposits. 

 

  

 

That money has been earning decent returns as cash rates have been relatively high. Unfortunately for savers, that's no longer the case and investors are looking for income elsewhere. That's not a new theme - I actually wrote about it in last years report (click here) - however it's one that I expect will continue throughout 2013. 

 

Key yield plays; ANZ, NAB, OKN, DWS, UGL, TLS, MIN, MTS, LEP, ALQ, SCP, WAM, BWP, SPN, WTF, FLT, SUN, MND, GEM

 

Another strategy that served us well in 2012 was having a relatively high allocation to fixed interest securities such as Bonds, Subordinated Notes & Hybrids, and we'll continue to maintain allocations to this area of the market. 

 

That's helped to reduce portfolio volatility, increase yield and offer retirees a more balanced income stream throughout the year (most pay quarterly distributions). Although we still hold a number of these securities, the majority are trading well over face value which has lowered yields. Generally speaking, we'll now prefer to look at new issues as they arise rather than buy above face value on mkt.

  

Key fixed income plays; ANZHA, WBCHA, CWNHA, HLNG, TTSHA, WOWHC, HBSHB, CTXHA, SVWPA, CBAPC.   

 

What about cyclicals in 2013? 

 

This brings up the obvious question of what now for cyclicals? Higher beta stocks that pay less in dividends, retain more profits for growth and are generally linked to global economic expansion. Contrary to some views mid last year, I don't think this part of the mkt is dead, and it will roar back to life if we see (as expected) an up tick in China and continuing improvement from the US. 

 

That said, I think the performance of some companies over the past few years has rendered them 'no go' areas for a portion of investors - and that's a valid decision. We all learn from our experiences and the misconception that BHP was bullet proof, China would continue to grow unabated, and Newcrest was the 'must have' Gold company in Australia, have proven somewhat misguided. 

 

By their very nature, the earnings of cyclical stocks are more volatile than some of the high quality industrials we've got listed on the ASX, but it cuts both ways. They'll under perform in times of weakness, and out perform in times of strength. The real issue was not in the stocks themselves, but the sometimes unrealistic expectations of those that owned them. 

 

If your portfolio has these stocks, as many do, you'll get a lower yield with more capital volatility. When things are good, you'll get more capital growth than your more defensive neighbour, but you've got to accept the added gyrations when they occur. Like many things in life, it's a trade off - and there's no such thing as the holy grail when it comes to investment. 

 

I guess the biggest lesson here is understanding the way in which things trade in a portfolio, and constructing a portfolio that is suitable for your stage of life.  

 

To sum up

 

I'm optimistic about the opportunities 2013 can bring. There are certainly risks around and I'm fully aware of the complexities that face investors globally. I can say with a degree of certainty, that mkts won't rise in a linear fashion, there will be pullbacks along the way and these will be our opportunities. I don't think we're in a mkt yet that needs to be chased. 

 

When the short term sentiment is bullish, hold your positions and enjoy the ride. When mkts pull back, as they invariably do, selectively add sound investments to your portfolio.

 

At the start of last year, we suggested the following investment structure. We don't think a lot has changed and it's still as relevant now as it was then...

 

- Hold a selection of somewhat boring, high yield securities >7% that offset a lot of growth potential with a higher degree of earnings certainty. By this we mean securities that pay a high yield now with the understanding that the income will probably stay static for the next few years. These can include stocks and hybrid style investments.

 

- Complement this with some stocks that pay decent yields >4% now, but have strong trends in earnings and an underlying driver that will see those earnings continue to rise. This should filter through to growth in dividends over time. 

 

- Combine options in the portfolio to smooth returns and take advantage of volatility. When we use options, we're primarily sellers of options (not buyers), with options being used to reduce risk, rather than adding risk to the portfolio.

 

- Consider using interest rate securities such as Hybrids to further reduce volatility and increase income. 

 

- Be active rather than passive in the market. The set and forget approach is dead and active management will be key in 2012 & beyond. 

The US MKT was LOWER overnight with the DOW JONES off by -42ptswhile the S&P 500 fell -0.20%. European mkts were LOWER  (FTSE off -0.56%, German DAX off -0.23%, French CAC off -0.79%), while locally, the SPI FUTURES are up +4pts, indicating a FLAT open this morning.  

 

At the close yesterday, the S&P/ASX 200 was up +11pts or +0.25% to 4424.It was an interesting session really with resources & resources related companies doing pretty well, while the banks flat lined. (look at MIN & ALQ as examples here). Telstra also came back from its recent highs. 

 

S&P 500; The movements in the US mkt over the next few weeks are going to be dictated by the political debate on the Fiscal Cliff. Always fun when politicians hold such influence...! 

 

S&P/ASX 200; 

 

NEW INVESTMENT OPPORTUNITY

 

MYOB Subordinated Note; MYOB launched a new offer yesterday that looks quite similar in structure to an existing security that we've been involved with, being the Healthscope Subordinated Note. That security has performed very well after listing at $100 (currently $108.50) and paying 11.25% fixed.

 

There are of course two parts to an offer like this; 

 

1. The structure of the security being offered 

2. The financial health of the underlying company (issuer). 

 

Here's some general background on the Note; 

 

MYOB will launch a $125 million listed note offer (max $155m capacity) which we can apply for within the book build process. 

 

MYOB is owned by private equity (Bain Capital) with the company seeking funds to reduce debt and create a pool of capital for potential acquisitions. As most of you probably know, MYOB provides accounting software to small and medium businesses. It was sold by Archer Capital to Bain Capital in September, 2011 for $1.2 billion. 

 

That buyout was financed by a $530 million five-year loan which pays an interest rate margin of between 450 basis points and 275 basis points depending on the leverage of the company & approx $550m of equity by Bain.  

 

As mentioned above, its a similar situation to Healthscope (owned by TPG and Carlyle) who raised $200m in Nov 2010 - (we still hold these in some portfolio's however reduced them recently for more conservative investors.)

 

Structure; 

 

* It's a subordinated note which means it sits below senior debt in the capital structure - it's a form of Mezzanine funding. That said, its higher in the capital structure than Hybrids & Common Equity (including Bain's $550m investment.

 

* The note will pay 6.70 - 6.90% over the bank rate, with a min rate of 10% for the first 4 interest payments. That's paid quarterly in arrears

 

* There's no doubting it's a good rate but that's because the note is subordinated to the senior debt Bain used to finance the original purchase &, as is the case with most private equity transactions, the underlying company is more highly geared than a listed entity is likely to be. 

 

* On the positive side, if distributions are deferred, they are cumulative and compounds quarterly at the interest rate plus 2.00% p.a - which provides enough of an incentive for the company not to defer payments. This varies from recent issues such as Bank of Queensland, CBA etc that are non cumulative.  

 

* The term is also relatively short, being 5 years which compares favorably with a number of the recent issues that can have had extended maturity dates - up to 72 years in some cases. 

 

* If an IPO occurs during the life of the Note, eligible holders of Notes will receive a priority right to subscribe at a discount of 2.5% to the price per security offered to retail investors

 

* The Notes are expected to be listed on the ASX giving holders the ability to exit at any time (liquidity permitting) 

 

 

Financial Health of MYOB

 

* MYOB was bought for $1.2b in 2010. The transaction was funded in part by $530m of senior debt while Bain Capital invested approx $550 million . After the issuance of Notes, MYOB Group will have approx $476.6m of senior debt which will sit above the $125m of Subordinated debt.

 

* MYOB can increase that Senior debt by a max of $62m, meaning there can be $538m that ranks in priority of the Notes

 

* The Senior Leverage Ratio currently sits at 4.04 times. Under the senior Facilities Agreement (existing loans with banks), a default event occurs if this ratio goes to 5.60 times & payments on the Notes will be suspended.  

 

* As it stands , and after payment on interest of senior debt, net operating cash flow of $45.4m is available for payment of interest on the notes - which will total $12.5m - so there is some room within the current structure for some deterioration in earnings before it will have an impact on Note Holders

 

* From a cash flow perspective, MYOB generated $212.7m in revenue & booked EBITDA of $98.5m 

 

More information on their Financial Health can be found in the Prospectus which can be downloaded here 

 

 

Our View; Clearly a higher risk offer given the ownership structure and subordination of the debt, however the company is financially sound, the note has a relatively short duration and we think investors are compensated for the risks. 

 

 

To SUBSCRIBE, read the prospectus, reply by email or call (02) 9375 0117. Bids need to be placed AS SOON AS POSSIBLE as these offers have been closing early in recent times due to strong demand. The book build is expected to take place on the 3rd December but could happen earlier. 

 

  

COMMODITIES  

 

James Gerrish is a Portfolio Manager with Novus Capital 

The US MKT was HIGHER overnight with the DOW JONES up by +207pts while the S&P 500 added +1.99%. European mkts were HIGHER (FTSE up +2.36%, German DAX up +2.49%, French CAC up +2.93%), while locally, the SPI FUTURES are up +29pts, indicating a HIGHER open this morning.  

 

At the close yesterday,  the S&P/ASX 200 finished up +24pts or +0.57% to 4361. So the mkt bounced yesterday from oversold levels and that theme is likely to continue today, probably with a bit more velocity. 

 

A couple of reasons underpinning the strength in the US overnight; 

 

* Fiscal Cliff negotiations appear to be progressing well with Obama expressing a degree of optimism

 

* US housing data was stronger than expected and ads further evidence that the mkt there has bottomed. 

 

* MKTS were oversold and we're entering a period of seasonal strength into Christmas. 

 

 

S&P 500 - Bounced from oversold levels 

 

 

S&P/ASX 200

 

  

CONTANGO MID CAP INCOME - LISTED INVESTMENT COMPANY 

 

We discussed Listed Investment Companies yesterday sighting the opportunity in WAM we had back in August. 

 

There is another interesting opportunity in a new LIC called Contango Mid Cap Income, that is in the process of raising $200m for a December 20 listing. 

 

The book opened on Friday, interest has been high and they're closing the offer on the 6th December. 

 

Main Points;

 

* Raising up to $200m to focus on mid cap industrial s. Drilling down this equates to the ASX 300 minus the top 30.

 

* By purchasing shares in the IPO at $1, you receive 1 free option with a strike price of $1 and 12 month expiry - these will be listed on the ASX. So the same principle applies as was the case with WAM. If the LIC rallies in the 12 months, an investor has the potential for twice the upside (share plus option) whilst only the downside of the share itself. 

 

*  The LIC will target a minimum yield of 7.2% of the NTA at 1st July. This is paid quarterly in Feb, May, Aug, Nov from listing (i.e 1.8% each qtr).  The maiden dividend will be paid on 28th Feb 2013

 

*  Another feature is a buy back clause, where if the share price is more than 10% below the NTA for a month, the company will go onto mkt and purchase up to 1% of the issued capital back. This will be capped at 10% per year and provides some more assurance that the LIC is likely to trade around NTA. 

  

* LONSEC have done a research report on the offering which can be downloaded by CLICKING HERE

 

* Anyway, I think it looks interesting and could be worth some consideration in the next week or so. If you'd like a full prospectus, please email me.  

 

 

VALUATIONS & FINANCIAL CONDITIONS; Goldman Sachs put together some interesting research that looks at the relationship between financial conditions and equity valuations. They call it the Financial Conditions Cyclical Clock (FCCC) and its main aim is to determine average PE's in the context of prevailing financial conditions. (conditions are a derivative of fiscal & monetary policy - currency etc). 

 

 

They draw a number of observations from the chart above; 

 

* Peak multiples for the ASX 200 (an average of 15.1x over the past 20 years) are observed when financial conditions are loose, BUT have started to contract (2 o'clock on the FCCC).

 

* Trough multiples (average 11.8x) tend to occur when conditions are tight, BUT the easing cycle has already commenced (8 o'clock).

 

* Defensive industrials tend to find valuation support earliest in the easing cycle, experiencing their largest P/E expansion when financial conditions move to neutral. Unsurprisingly these sectors are the least sensitive to the cycle.

 

* Financial valuations tend to be the next beneficiary. REITs and Diversified financials first, followed by insurance and banks as conditions move to loose.

 

* Cyclical industrials tend to hit peak multiples as conditions are loose, but beginning to contract. Metals achieve their most significant multiple expansion at the end of the cycle.

  

  

"While the market has been quick to re-calibrate valuations to be broadly in-line with those of similar phases, our base case is for financial conditions to be firmly within a loose setting by early to mid-2013 (75bp of rate cuts, plus >5% correction to the $A). 

 

A shift to the 12 o'clock phase (loose and expanding financial conditions), implies 13% upside to current levels across the broader market, 18% in resources and 27% across the cyclical industrials."  (Goldman Sachs)

  

 

LYNAS; AGM today and it's expected to be a pretty fiery affair with Executive Chairman Nick Curtis likely to be reminded of comments he made at last years AGM....''This time next year I will not be reporting to you the sales we are about to achieve, but rather celebrating with you the reality of our production and sales, and speaking again of the huge potential of our business,'' Mr Curtis said at last year's meeting. 

 

Clearly, the company is still struggling with approvals/protests etc and they've had to launch a cap raising as a result of the delays - $150m of which has been done through institutions (at 75c) while $50m is left for retail holders. At this stage, it looks like the underwriter (JP Morgan) will be left with a large amount given rights price of 75c v current share price of 63.5c.  

  

 

QANTAS; The proposed Qantas-Emirates alliance could be terminated if a group of former Qantas executives and their financial backers purchase a stake in the Australian carrier and agitate for an alternative strategy.

  

Under the terms of the 10-year agreement, which is before the competition regulator, either party can terminate the alliance should there be a material change in strategy or an "inconsistent investment" under which a third party secures control, a stake of more than 20 per cent, or more than 10 per cent and a board seat. (AFR) 

  

WESFARMERS; There is now talk that Wesfarmers could be a buyer for Coates Hire which is tipped to attract offers in excess of $3b when bidding heats up in January. Wesfarmers has been out of the mkt since the 2007 purchase of Coles - where some think they paid too much - but Goyder has now declared they're looking for avenues of further expansion. 

 

Here's a good chart published in the AFR this morning that gives a sum of the parts valuation at $36.28

 

   

COMMODITIES   

 

James Gerrish is a Portfolio Manager with Novus Capital 

The US MKT was FLAT overnight with the DOW JONES unchanged while the S&P 500 put on +0.01%. European mkts were MIXED (FTSE off -0.04%, German DAX up +0.07%, French CAC off -0.35%), while locally, the SPI FUTURES are unchanged, indicating a FLAT open this morning.  

 

At the close yesterday,  the S&P/ASX 200 finished down -14pts or -0.31% to 4448.  So the mkt is hanging around the previous breakout region (4450) and at the moment, it doesn't seem there is a lot of aggressive selling activity about generally. That's a different story on a stock specific level where bad news is punished as was the case with QBE yesterday (more on that later).

 

Looking from a bottom up perspective...the ASX 200 is trading on 12.3X forward earnings. Resources are trading at a 19% discount to Industrials - 10% below the 10 year average (Goldman Sachs)   

 

S&P 500; 

   

 

Source; IRESS 

 

 

S&P/ASX 200;

  

Source; IRESS   

  

 

* QBE; Came out yesterday and disclosed an expected $355m hit from Hurricane Sandy. That's well ahead of the last major storm that hit the US (Irene) which had a bottom line impact to QBE of $50m. It was also well ahead of most expectations with Deutsche suggesting it would be in the 10s of millions of dollars.....

 

* The stock was smashed -12% early on, but strong buying throughout the session saw it close almost $1 from its intra session low - buying the dip  

 

* Clearly a negative but I don't think it was the main concern from a mkts perspective yesterday. Only 4 weeks ago, QBE guided the mkt to a profit of $1.75b, with new CEO John Neal highlighting the improvement in the US business

 

* This was during a US roadshow where Australia's leading insurance analysts were told that everything was fine - and profit was expected to be $1.75 billion. 

 

* Now, profit is expected to be $1b, which although is about +30% up on last years effort , is a significant hit from the $1.75b expected. There's not too many companies globally that see's expected profit slide from $1.75b to $1b in just 4 weeks...!

 

* But, it's not all Sandy's fault... there were other issues at play that caused such a significant change in expectations. One of the main concerns from a mkts perspective was the admission that a portfolio of about $1 billion in premium income had inadequate reserves despite being topped up in the half year.

 

* On the read through, it suggests a lack of understanding of some parts of the business and I think this is one of the major issues that has plagued the insurer in recent times. As one of the guys here said yesterday, whenever QBE starts to look good, they come with some negative news. This erodes confidence and investor goodwill that arguably, is at a low point right now. 

 

* That said, the business is in a turn around phase and it seems the low point in earnings has passed. I think John Neal will bring a more disciplined approach to the business and I remain of the opinion that it's times like this where pessimism is high that we'd rather be adding to a cyclical business than reducing it. 

 

* I was listening in to the call with the CEO and CFO yesterday, who answered all analysts questions with openness, and presented a path forward for the company. 

 

* Here's a chart of historical earnings for QBE with 2012's number being the forcasted print. Earnings were expected to follow the trend of the red line (+1.75b). After yesterdays update, they'll now follow the blue line (circa $1b). So instead of a very strong re-bound, it's going to be a sluggish rebound in 2012. 

 

 

QBE earnings

 

 

Source; IRESS 

 

 

BANKS; we've been of the opinion recently that banks had been fully valued. Although we continue to hold them, we hadn't been increasing our exposures at these levels. 

 

I think the case for banks remains compelling based on the simple fact that interest rates are coming back, term deposits are getting less competitive and self funded retirees need to preserve their way of life. 

 

This has been one of the major reasons we've seen stocks in the US outperform our local mkt - the search for yield as 10,000 baby boomers turn 65 every day in the US. 

 

Here is a telling chart we showed last week but worth re-printing...highlights one of the main reasons why the US stock mkt has continued to see support, and we think this highlights one of the reasons why out mkt will be supported going forward. 

 

Yields in other asset classes have been crunched as a result of central bank intervention. 

 

  

* INCITEC PIVOT (IPL); came out this morning with their full year result  booking a 10% increase in full-year net profit, but earnings fell 24% excluding one-off items as the contribution from the fertilizers business dropped.

 

* The explosives business is the main driver of growth for IPL with Dyno Nobel tipping in 60% of earnings - an 8% rise on the year. 

 

* Fertilizer's did drag while the second half was down on the previous year, suggesting a softer read through for next year. Importantly, the start up of the Moranbah ammonium nitrate plant in Queensland is on time and on budget. Stock should be higher on this result. 

 

 

COMMODITIES

 

DUAL LISTED COMPANIES 

  

 

In New York, News Corp fell by US$0.07 to US$24.67, equivalent to A$23.67, A$0.17 below its last close on the ASX.

ResMed fell by US$0.51 to US$31.58, equivalent to A$3.03, A$0.85 below its last close on the ASX.

In London, Rio Tinto fell 18.0 pence to £30.81, A$0.27 lower in Australian currency terms.

BHP-Billiton was unchanged at £19.51.

Henderson Group Plc was unchanged at £1.12.

 

 

James Gerrish is a Portfolio Manager with Novus Capital 

Bank of Queensland has launched a new Hybrid offer in an attempt to raise $200 million. The structure is similar to the recent CBA PERLS offer however the yield is higher to compensate for the added risk of the issuer.    

 

Whilst we think the yield looks attractive, our preference in the past has been with the lower risk, subordinated note structures that covert to cash at maturity. Unfortunately, these are likely to be a thing of the past! 

 

These issues that we've previously recommended (WBCHA, ANZHA etc) would not be Basel III compliant.   Going forward, all new Tier 1 hybrids issued post January 1, 2013, must be Basel III compliant and we're starting to see a few of the recent issues complying with the new regulations (CBA PERLS VI for instance) 

 

The most significant change is that capital must be permanent.  In other words, all Tier 1 capital issues will be converting preference shares with a mandatory conversion at a specific date or on an event. This varies from the likes of WBCHA and ANZHA where capital will be returned at maturity. 

 

From now on, all Basel III compliant Tier 1 hybrids require conversion clauses or terms that include a Non-Viability event and a Capital event. 

 

For instance, if the common equity ratio of the issuing bank falls below the specified ratio (capital event) as per APRA's requirement ( 5.125% in the case of a capital event), Basel III compliant Tier 1 capital will be forced to convert to ordinary shares. 

 

In a nut shell, this means that new Tier 1 hybrids that are Basel III compliant are higher risk than previous hybrid issues and this should be taken into consideration when considering the trade off with yield. 

 

Anyway, back to Bank of Queensland where they're looking to raise $200m by issuing convertible preference shares paying a semi annual distribution of 5.10% to 5.30% over the 180 Day Bank Bill - that equates to a yield of 8.24% to 8.44% (inclusive of Franking) depending on the book build process.

 

Although that yield looks attractive, there are a few conditions that you need to be comfortable with before accepting it.  

  

The issue is structured as a Convertible Preference Share. If you draw a line in the sand with equity on one end and debt on the other - it sits just above common equity. The issue is perpetual which means that the security does not mature at a set date in the future - however BOQ must exchange the security on the Mandatory Exchange Date - This occurs on the 15th April  2020. (They can also elect to redeem before this date in 2018 however there is no real incentive for them to do so)  

 

On this date, you get $101.01 worth of BOQ shares - but that's determined by the stocks 20 day Volume Weighted Average Price (VWAP) which means you have exposure to the shares for a certain time. 

 

Another curly aspect is that conversion can only occur if certain conditions are met - which amongst other things says the share price must be above 56% of what it is now. You'd presume that would be the case but it's an added risk particularly given the exposure the company has to the  QLD property mkt. APRA also imposes a few conditions that could mean the securities are not redeemed on this date - and continue trading until they are met.  

 

Another important consideration is that dividends are discretionary and non cumulative - meaning management can stop paying dividends at their discretion. That in itself is not hugely uncommon given that management would then be required to suspend dividends on the underlying stock - which generally provides enough of a disincentive.  Both the Caltex and Crown notes we covered recently had this condition within them. That said, the dividends with both Caltex and Crown were cumulative, meaning any missed payments accrued and would be paid at a later date. That's not the case with the BOQ issue nor was it the case with the CBA PERLS or Suncorp issue.

 

In contrast, the securities in the financial space we currently hold (WBCHA and ANZHA) don't have a mandatory conversion trigger, they are not convertible into shares, distributions are mandatory and capital is paid back at the maturity date, making them clearly lower risk (and they pay a lower yield as a result). 

   

Our View;  We hold a number of these type of securities in client portfolio's and feel they offer yield, capital stability and a higher degree of certainty than an equity only portfolio. That said, not all these securities are the same and some have conditions we feel are just too obscure. 

 

Equally important is understanding how they might trade given they're listed on the ASX. To gain insight here we look at existing issues that carry similar structures. ANZ has a number of existing preference shares on issue under codes ANZPA, ANZPB and ANZPC. They are all trading on or above their $100 face value. The CBA PERLS which we discussed recently, are now trading around $103 - well above their $100 face value. 

  

Although we think the new structure of Hybrids (that comply with Basel III) are higher risk, it seems this will be the preferred structure for issuers going forward. This has sent the more vanilla type products such as the Subordinated Notes in ANZ and WBC higher as investors pay up for the better conditions.

  

As always, it's a question of whether the yield compensates for the risks. In this case, I think the yield compensates for the added complexity of the actual Hybrid, but you've got to make a call on the exposures that BOQ have to QLD property. 

  

Personally, I have some reservations around the financial strength and risks of the underlying company because of that exposure, however I do note that the CFO came out with the below comments recently.... 

 

"There seems to be a clearing price at the moment at which assets are starting to turn over and change hands, which probably wasn't as evident over the last couple of years," Mr Rose said. "In particular, in those regions where there has been a more significant deterioration in asset values." 

 

These comments suggest the struggling Queensland property market is showing early signs of bottoming - according to BOQ

 

 

 

 

James Gerrish is a Portfolio Manager with Novus Capital