An elephant tiptoes into the market

In the late 1990s early 2000s the US equity market was supported by the so called "Greenspan put". The theory was that Alan Greenspan, chairman of the US Federal Reserve, would pump massive liquidity into the system at any sign of sustained US equity market weakness. The "Greenspan put" was effective, with excess liquidity pumped in during the Asian crisis and the tech bust. This liquidity eventually supported equity prices and it was effective a "put" for equity investors.

In an Australian context, traders and hedge funds are now talking about "the Future Fund put".

Something changed in the Australian equity market last week. We watch the price and trading action in Australian equities very closely, and to our eyes a new big player arrived last week. Every day around 11am the whole tone of the market changed. The market went bid, starting at the largest index weight, BHP, and it was absolutely clear that someone was buying an index tracking basket in large scale.

Even on days when the overseas market price action was quite negative, the Australian equity market hardly opened down, which suggested that traders and hedge funds knew the market was underpinned by something large. That something large in our opinion is the Federal Government Future Fund initiating investment in Australian equities.

The giveaway that it is the Future Fund is the fact all the largest index weight stocks are well bid except for Telstra (TLS). When the buying comes in it doesn't include Telstra, and that almost ensures this price action is the Future Fund because Telstra is the only stock it is currently overweight (and don't need any more of). Call me an amateur detective but it has to be the Future Fund starting to nibble.

Back to the future

The Future Fund was established to meet the unfunded superannuation liabilities of the Commonwealth Government by 2020. Although the investment mandate is still unclear, the funds are to be administered by the Future Fund Board of Guardians, with a target rate of return 7.5%. I understand the Future Fund is exempt from tax, but has the ability to utilise any franking credits of listed domestic investments. Wouldn't mind that deal myself!

At the last budget, the unfunded liability was estimated at $103 billion, to reach $148 billion by June 30, 2020. The Future Fund was seeded with $18 billion in 2006, however at June 30 this year, the total was $52 billion. Considering the budget surplus was about $13.5 billion, and the newly created Higher Education Endowment Fund was seeded with $5 billion, another $8.5 billion is expected to be transferred to the Future Fund this year, making a total of $60.5 billion. It is unclear whether any further funds will be added in future. Therefore, assuming a 12-month return of 7.5% and the transfer of approx $6.5 billion from the second T3 instalment, the total assets are expected to be about $72 billion by June 30, 2008. Assuming the targeted 7.5% rate of return is achieved, the fund is expected to have total assets of about $171 billion by June 2020.This is truly a mind boggling figure

A further equity driver

I believe the introduction of the 10% superannuation levy, and the implementation of the tax imputation of franking credits, have been very powerful drivers of the Australian equity market over the past decade. In effect, both initiatives have increased the tax-effectiveness of equities over other asset classes (we should all thank Paul Keating). In addition, we think both have significantly contributed to the recent relative outperformance of domestic equities. Australian equities have achieved a rerating of their price/earnings multiples relative to the overseas peer group due to the tax-effective nature of equities within the super structure.

There is little doubt that last year's budget changes have further increased the tax-effective returns of super compared to property or fixed interest investment. However, I think the implementation and the effect of the Future Fund will add another dimension to the Australian equity market. It will add unprecedented liquidity to domestic equities at a time when the market cap of Australian listed companies is shrinking significantly through share buybacks, private equity takeovers and the reluctance of retail and domestic investors to crystallise capital gains tax liabilities by selling equities. It is worth noting that at the end of 2007-08, assuming assets of $72 billion and a 35% domestic equity allocation, the Future Fund will have the capability to invest about $25 billion into domestic equities, rising to $60 billion in 2020.

People often make the mistake of believing the $6 billion of reported turnover on the ASX each day means leading Australian stocks are deep and liquid. In my opinion, when you strip out all the broker churning, CFD trading, and other forms of day trading, the "real liquidity" for something like the Future Fund to take advantage of is actually much smaller than implied by the headline turnover figures. This means its "real" impact is going to be much larger than they or anyone expects.

Elephant in a strawberry patch

Make no mistake, the Future Fund is an "elephant". The Future Fund will be the biggest Australian fund manager and, with a 35% weighting in Australian equities, will be the largest owner of Australian shares. To be 35% weighted in equities, and to meet its targets, the Future Fund will eventually need to have nearly $25 billion invested in the domestic equity market by the end of 2007-08.

Let's assume it index-replicates the ASX200. To even get to the 9.36% index weight BHP Billiton commands, the Future Fund would have to buy 65,915,549 BHP shares. To get to the CBA index weight of 5.62%, it would have to buy 25,545,545 CBA shares; and for NAB (5.25%) it would require 32,621,951 shares; along with 2,500,000 Fortescue Metals shares and 12,222,222 Paladin Resources shares to match their index weights. This might appear to be only a few weeks’ turnover, but the reality is it will take 12 months.

Yes, I am doing back-of-the-envelope calculations using assumptions on Future Fund investment that may or may not prove to be correct. However, even if I am half-right on the amount of leading stocks it needs to buy to replicate indices, the scale of the buying support is enormous. For example, I have been buying BHP, NAB and Commonwealth Bank for institutional investors over the past few weeks and even buying 500,000 of those stocks is not easy because there simply isn't any real institutional selling about. Even buying 500,000 shares in a leader has an impact cost, let alone what happens in a Fortescue or Paladin.

A sellers strike

One of the key reasons there isn't any real institutional selling around in leading stocks is because we are approaching June 30. Fund managers don't want to detract from their own potential performance by holding back the performance of one of their holdings by selling, while concurrently many I speak to do not want to crystallise any more capital gains this financial year.

I also believe retail investors don't want to crystallise any more capital gains this financial year, and remember it's been another cracking year of capital gains. The more likely scenario is that everyone is looking to crystallise a tax loss if they can find one, and I expect to see some aggressive tax loss selling over the next week. There could be some interesting opportunities in high-profile "losers" this year, and I think Emeco (EHL) could be the classic one that gets belted to a give away price on tax loss selling.

Getting the ASX20 right

I was having a look at the ASX20 over the weekend (yes, another exciting weekend in the Aitken household), as it's really the ASX20 you have to get right to get the index right. If you get the ASX20 wrong, it's not going to be easy to beat the broader benchmark index.

The clearest point about the ASX20 is just how little new equity the stocks are issuing. Westfield Group (WDC) recently raised $3 billion, Suncorp-Metway (SUN) $1 billion, and Macquarie Bank (MBL) $750 million. Other than that there has been no equity issuance. On the other side of the equation Rinker (RIN) is about to be lost for good, and takes $16.6 billion of market cap, while Coles Group (CGJ) is all but gone and takes with it $18.6 billion of market cap. Some of that will be swapped to fellow ASX20 member Wesfarmers (WES), but the supply/demand equation in the ASX20 remains heavily in favour of demand.

I though it would be useful to quickly swing through the ASX20 and see how it looks. These 20 stocks represent 59.1% of the ASX200 index. I have also attached the consensus 2007-08 price/earnings multiples, earnings per share growth and dividend yield forecasts.

AMP: Excess capital, open register, corporate target (19x, EPS 8%, yield 4.5%)
ANZ: Excess capital, new management (12.4x, EPS 10%, yield 5.2%)
BHP Billiton: Excess capital, new management, massive balance sheet options (10x, EPS 10%, yield 1.4%)
Brambles: Excess capital, no gearing, clear private equity target (22x, EPS 6%, yield 2.5%)
Commonwealth Bank: Excess capital, new management, cultural change (14.6x, EPS 11%, yield 4.9%)
Coles Group: Gone
Foster’s Group: An obvious private equity target (16x, EPS 14%, yield 4%)
Macquarie Bank: Well capitalized after recent raising, fingers in every pie (14x, EPS 8%, yield 4%)
NAB: Excess capital, excess franking credits, Chaney factor, UK assets to go (14x, EPS 11%, yield 4.8%)
QBE Insurance: Excess capital, great company, great management (13.8x, EPS 11%, yield 3.8%)
Rinker: Gone
Rio Tinto: No gearing, great assets, new management, corporate target (11.5x, EPS 10%, yield 1.3%)
St George Bank: Customers and shareholders happy (14.7x, EPS 11%, yield 5.2%)
Suncorp-Metway: Digesting Promina, now well capitaliszed (13.7x, EPS -5%, yield 5.6%)
Telstra: Excess everything, agitator fund target (14.7x, EPS 2%, yield 6%)
Westpac: Warren Buffet says they're cheap (13.8x, EPS 10%, yield 5.5%)
Westfied Group: The biggest, cheapest, and most transparent LPT (19x, EPS 5%, yield 5.2%)
Wesfarmers: Yields 6% fully franked before they get Coles (17.5x, EPS 14%, yield 6%)
Woolworths: Nothing to worry about here (21x, EPS 15%, yield 3%)
Woodside Petroleum: Talk of corporate action again (17x, EPS 30%, yield 3.2%)

You may well think what I have written above is far too simplistic, but when you look at the $712 billion of ASX20 market cap above there really isn't much to worry about. In fact, these companies have such strong balance sheets that they will grow by acquisition, re-gear and return excess capital in one form or another; or attract private equity players who will do it for them. All these numbers are based off consensus, and you can see that earnings per share and dividend growth will more than likely prove conservative, particularly in BHP, Rio and Woodside.

Biggest = cheapest

As I keep writing, the ASX20 remains the cheapest index in Australia. Our largest capitalisation companies are our cheapest and lowest geared, which means in risk-adjusted terms they are far and away the most attractive place in the market. The good news is that the new generation of chief executives and chairmen is moving into the ASX20, and they know how to "use it or lose it".

I think people like Marius Kloppers at BHP, Sol Trujillo at Telstra and Michael Chaney at NAB, for example, will bring a whole new dynamic "asset manager" style to these giant diversified businesses. They have so many options to release and create long-term shareholder value and they won't be scared to think like private equity. I expect to see the ASX20 members get far more aggressive, while maintaining economic discipline, and I think you can see this starting in Wesfarmers’ cleverly structured yet aggressive bid for Coles Group. Everyone (except my firm, Southern Cross Equities) said the Wesfarmers model couldn't compete with the new generation of private equity investors, but at this stage it seems Wesfarmers has beaten all the rivals for Coles.

I think you can see these ASX20 companies becoming far more dynamic before your own eyes, and, quite frankly, I reckon this is a great development. The threat of private equity is clear and present, and it's making large cap corporate Australia get on the front foot and consider more dynamic strategy. As a shareholder in large-cap companies this is a very good development.

Eat or be eaten

The clear message to Australian boards is to eat or be eaten. Liquidity is huge in the world, and lazy balance sheets are the clearest target of all. Boards have to think outside the square to create shareholder value, and they may have to consider options they previously have shunned.

It's the giant diversified companies who have the most options to create shareholder value. The market is putting a discount on diversified companies versus their more leveraged pure play cousins, and this is true across all industries. You only have to look at the re-rating of Toll Holdings (TOL) and Asciano (AIO) since splitting into pure play vehicles to realise the value that can be released by this style of demerger.

I am certain that the success of the Toll de-merger, which has seen both asset bases re-rated as pure plays, will make corporate Australia and its advisors think about the most appropriate corporate structures.

Spin-offs are winners

Just about everything that has been spun-off out of a major diversified company has been a raging stand-alone success in recent years, or been taken over (Rinker, Highlands Pacific, WMC, Alumina, Ansell, Cochlear, Ramsay Health Care, Mayne Pharma, BlueScope Steel, OneSteel, etc). At the moment the diversified model commands a significant P/E discount. I think the way forward to release value in diversified companies is partial spin-offs of hidden value assets while maintaining effective control of the assets.

This is particularly relevant in resources. Look at BHP Billiton trading at a discount to its pure play friends despite having better assets and a better balance sheet. Let's pretend to be Marius Kloppers for a day. How do I release some value and reduce the discount? First, I put all my petroleum division and uranium assets into a "newco" called BHP Energy. I spin off 49% to the public via an in-species distribution to shareholders, which shareholders could either take up or sell to new investors. BHP has the best uranium assets in the world (Olympic Dam), and great petroleum assets, yet the share price in no way reflects that. The "newco" would trade on 15–20 times earnings, and I have immediately created a new top 20 company ($20 billion market cap) and released value.

Then I would do exactly the same with my iron ore infrastructure assets in the Pilbara: spin off 49%, maintain control, and get the 20 times multiple that Asciano (AIO) commands for arguably inferior assets. I have then created a new Top 50 company and released shareholder value instantly. There are just two basic ideas that see BHP maintain control of its assets but create a see-through pure-play multiple for the assets that will lift the multiple applied to BHP.

It's all about releasing the inherent value hidden inside the BHP share price. This is the sort of stuff I and others would love to see BHP do, and the market is in desperate need of new long-duration companies to feed demand from legislated compulsory superannuation. It would get the BHP share price re-rated and make its acquisition currency more valuable.

Pending demergers that will clearly add shareholder value include Zinifex and Publishing & Broadcasting, while there is speculation that Telstra is considering demerging the Sensis business. Foster’s would also be rerated if it split into separate beer and wine companies. Both divisions of Foster’s would be clear corporate targets if they split, and right now with a 4% dividend yield, Foster’s is all but a self-funding option on corporate action of some form.

We are entering a period of much more aggressive corporate strategy in Australia where more economically optimal outcomes are achieved. Why have private equity release value when you can do it yourself?

Take advantage of short-term volatility

It's always a fund called something like "High Grade Structured Credit Strategies Enhanced Leverage Fund" that gets into a mess. All I know is that a few paper losses by US investment bank hedge funds won't stop 1.2 billion Chinese wanting a better life. Use this volatility to accumulate Australian long-duration companies, and the best risk-adjusted place to start is the ASX20. The Future Fund seems to be starting to implement this strategy, so should you.