Celebrating a little spark of madness

July rebounded after a weak June, led by resource names, which saw the ASX200 hit its highest level since before the GFC. Globally, equity markets struggled through the month, but the Australian market enjoyed its best returns in six months as resources stocks led the charge, especially the major iron ore names. This reward via cash flow rather than growth may yet prove to be but a little spark of madness in

a market that has narrowly rewarded the short term. A 2% rise in the iron ore price coupled with strong

production data and a low base effect saw Rio Tinto and Fortescue perform strongly, as indeed did BHP.

Even our long standing position in Alumina brought some joy, as did Iluka, reflecting a strong production

and cashflow report overwhelming the negatives attaching to its proposed takeover of Kenmare. The

resource sector has moved to a cash harvesting focus rather than a capex led production growth focus;

low cost producers are generating strong cashflow with this change in strategy, although higher cost

producers continue to struggle. We suspect this may be ongoing, given as many commodity prices still

remain above our long term price assumption, as not.

These moves assisted the portfolio performance, however fundamental upside remains for some stocks

where several years of poor market performance, see them now trading well below replacement cost.

Take Alumina, for example, where the current market value of approximately US$500/tonne is less than

half the cost to build capacity in China, and one third of the cost to do the same in the Western world.

These new assets also have higher operating costs than Alumina’s assets. Notwithstanding this higher

cost position, Chinese capacity in the global Aluminium industry has grown from 30% in 2009 to 45%

today. As we highlighted in detail by reference to Chinese capacity additions in the steel, cement and

glass industries in this commentary two months ago, the world continues to be long manufactured goods,

and pricing power remains scarcer than ever for manufacturers.

The buoyancy in miners lifted mining service names as well, with Orica and Leighton enjoying strong

performance through the month, although ALS struggled. Orica and Leighton, like QBE and Coca-Cola

Amatil, are in the twilight zone, where a new CEO is grappling with a business under operational stress

and market confusion over the legitimacy of the inherited (and previously lauded) corporate strategy. In

every case, share prices have been volatile and are likely to remain so until portfolio reshaping is

complete. Of these names, we are overweight Orica, and continue to believe that if it can earn $800m in

EBIT or more through the next several years, given a base of $950m plus or minus $75m every year for

the past cycle, then the current market capitalisation of $7.6bn provides an attractive entry point. By way

of contrast, many other industrial cyclical stocks are trading at much higher enterprise value multiples,

even when they are operating in a more generous operating environment (such as those exposed to

residential construction in Australia, now that housing starts are annualising near decade highs). It is

tempting to believe that those stocks – such as Boral and Fletcher Building – are in an upgrade cycle

whereas the chemical stocks are in a downgrade cycle, but the evidence of that supposition through the

past 12 months is scant.

It may be that AGL and Origin will enter the “new CEO strategic twilight zone” phase through the next two

years. Michael Fraser of AGL has already announced his intention to retire and Grant King from Origin

may not be far behind. “Peak power” consumption in Australia off the grid may have happened; the

Energy Supply Association of Australia has called “peak electricity” for Australia, in 2008. Just as “peak

newspaper” happened in 1990 and “peak landline” in 2003, this need not presage a quick death of

profitability for energy providers (although we wouldn’t rule out a slow one!). It does, however, mean that

continuing with a “build it and they will come” strategy is at best brave, and perhaps negligent. With

national electricity demand now 10% off peak levels and but still above global benchmarks on a per capita

basis, and with the rate of solar installation continuing apace in the residential market and about to

materially ramp up in the commercial market, winning strategies through the next decade are more likely

to resemble that of the major miners in recent years – improving asset turnover by focusing on cost and

capital efficiency - than what we saw with Telstra in the immediate aftermath of peak landline – asset

growth. We are overweight the Energy sector, but frustratingly it is a sector still characterised by a focus

more upon asset growth than return, and shareholders continue to bear that cost. To change this focus,

which as the major miners have proved requires little more than a mindset change and the will to execute

for a leading player in a mature industry with significant capital barriers to entry, is a burning strategic

imperative for the boards and incoming senior management of each of AGL and Origin.

David Jones was delisted during the month, after Woolworths of South Africa completed their $2.2b

takeover. While we wish the new owners every success, we struggled to see value in the group, at the

purchase consideration enterprise value of $2.3b. Sales and EBIT for David Jones are now at 2006

levels, and the acquired EBIT of $150m is about $100m less than its cyclical peak. Whilst not

shareholders, from afar our sense is that management were doing a good job in optimising the returns

available; but, given a starting cashflow yield of 6.5% at the purchase price, and cyclically tougher

conditions to come for Australian retailers, the new management have it all in front of them in proving the

value of their acquisition. No matter the fortunes of Woolworths with David Jones, we doubt we will have

it represented to us as a potential investment on the ASX anytime soon. Unlike Spotless and

Healthscope, which having spent several years away from listed markets whilst being held close to the

bosom of their loving private equity owners, have decided to rejoin the ASX family. Paying higher

multiples for the same asset bases of stocks we did not own before being delisted is not a strategy we

pursue often, and we resisted the urge to do so on this occasion as well.

The Woolworths mindset - that earnings from traditional retailers in Australia can at least be maintained -

is also interesting in the context of the Westfield restructure. Placing the Australasian assets into a

separately listed entity – Scentre Group – from those of the rest of the old Westfield Group will make the

judgement of the Lowy family upon the relative attractiveness of Australian and offshore retail assets

relatively transparent. Their judgement has clearly been impeccable for a long time; we doubt that will

change anytime soon.

Macquarie has had a good year but a poor month in July. We have held Macquarie for some time

because of its attractive funds management business and aggressive growth in the mortgage market, and

despite the poor returns from many of its more traditional market facing businesses. It is easy to misplace

the true economics of Macquarie today, where the funds management business reports a segment result

(all pre-tax and bonus) of $1bn, which is more than the market facing businesses (fixed income currency

and commodities, Macquarie Capital and Macquarie Securities), combined. The funds management

business is a powerhouse; its funds under management is more than double that of Colonial and three

times that of AMP’s, for example, and despite having a low level of equities in its business mix, its yield

(revenue to average FUM) is better than many peers at close to 60bps. Applying the multiple attaching to

many ASX200 listed funds management companies to this level of FUM for Macquarie more than

accounts for the current market valuation (not that we wish that sentence to be confused with any

insinuation that the high multiples attaching to some of these fund management businesses are, well,

prudent). It simply highlights how little value the market still affords the Macquarie balance sheet, which

we consider inappropriate given the delta in recent years has been more into the Australian mortgage

market than any other asset class. Australian financial stocks are fully priced, but the Interim Report of

the Financial System Inquiry (FSI) chaired by David Murray, released during the month, did little to

suggest any additional regulatory risks are likely to be placed in front of equity holders once the final

report of the FSI is published.

Portfolio outlook & strategy

After several years of exceptional total returns, amidst only moderate earnings growth, it would be

churlish to suggest that equity markets are absolutely cheap. For most domestic cyclicals, we suspect

this earnings season will confirm that earnings growth will continue to be derisory, whereas foreign

earners will prove relatively more robust. The best performing Australian equity investments in this

environment may continue to be price makers and management teams showing an ability to generate

productivity gains; the operational excellence candidates, such as James Hardie, Brambles, Woolworths

and Recall. As the RBA has noted, human nature means that productivity gains usually lag a poorer

economic environment, and hence Australia has a currently poor productivity environment, which is as

often a management issue as much as a union related or political one. A productivity focus, manifested in

strong free cashflow, will be a key ingredient for equity market outperformance amidst a local demand

environment that we continue to see as increasingly faltering as unemployment rises through the next

several years.