Behind the themes expressed in the recently completed reporting season, one stood out: the incredible influence the bond market is having on share prices. The impact of lower rates touched almost every sector, impacting the behavior of investors and company managers alike.
Take listed property trusts (A-REITs), for example. They continue to benefit from cap rate compression as low long-term interest rates raise the attractiveness of commercial property on long term leases. Smart owners are taking advantage of this. Witness Crown's proposal to spin off 49% ownership in most of its Australian hotels, the Viva Energy REIT float and Charter Hall’s Long WALE partnership listing.
If and when long term interest rates rise, this sector will be the first to show it in the form of lower share prices. Long average lease terms make them highly attractive in the current low interest rate environment but much less so if and when long term bond rates rise. But if and when that might happen is anyone’s guess.
Low rates driving markets in different ways.
Valuations beginning to look stretched.
It's risky when there is no sign of risk.
General insurers QBE Insurance and IAG had a rough year, facing pricing pressure, increasing competition and low returns from their investment portfolios (QBE didn’t even manage a 2% return). According to senior analyst Graham Witcomb – and no-one I imagine would disagree with him – there’s no value here.
In retail, Woolworths and Wesfarmers took the opportunity to wipe the slate on poorly-performing businesses with multi-billion dollar writedowns, signalling an end to the sector’s margin expansion and profit growth. In fact, many companies are trading on premium prices and have been downgraded, or are closer to being so. In the aftermath of the Woolies result, a stock only just removed from our Buy List, the share price surged 4% because the news wasn’t as bad as expected. It makes the point: there’s a general air of positivity factored into share prices that is not always matched by reality.
The big retailers have also let their dividends creep up at the same time as their debt levels. Realising they’ve been too complacent, both have cut dividends, as did Flight Centre. By contrast, JB Hi-Fi has been a beneficiary of the collapse of competition from Dick Smith and department stores vacating the consumer electronics space.
In resources, cost improvements were a big theme, although top line profits were hit by impairments and high depreciation charges from the boom years. Cash flows are much better and the top end miners (South32, BHP Billiton and Rio Tinto) are repairing balance sheets and even talking about spending cash again. Two were already on our Buy List but price rises put paid to that. It would be nice to get another opportunity in this sector. Mining services generally reported good results with higher cash flows and lower debt and the gold sector has been on a tear, not that that is in any way predictable.
It was a year of consolidation in the telecommunications sector where three giants – Telstra, TPG and Vocus – have emerged. None reported outstanding results and industry growth is slowing. Once a hot part of the market, it looks as though maturity is catching up. But after a 8% price fall since July, Telstra is looking more attractive (see below).
Large caps underperformed
There were a few standout results – Computershare’s prompted a 17% share price rise in a few weeks and Bellamy tripled profits and boosted margins and revenue – but large caps generally underperformed. With stretched valuations a few large fund managers are moving into small caps, pushing up the prices as a result. We’re hopeful of opportunities here when the inevitable disappointments force them out of their new found loves.
With growth stocks outperforming over the past year perhaps the ‘rush to yield’ has gone into reverse. With interest rates falling the market has been happy to pay up for stocks with good and growing cash flow, dismissing big yielding stocks like Telstra, the big four banks and IOOF where growth seems limited. But as James Carlisle says, with fully franked yields of 6% plus you don’t need much growth in this environment.
The banks will start growing again – eventually – and ironically the lack of growth (and the lower discount rate that results) means valuations are less dependent on near-term performance. Even more than ever, what matters is the long term and we expect the big banks to retain their privileged positions in our economy. That’s why they’re closer to an upgrade than other blue chips.
Perhaps more than usual, there were also some sharp price movements as some relatively unloved stocks came in better than expected, while others failed to match higher expectations. Ansell and Computershare rose 13% and 9% respectively, after reporting falls in earnings per share of 14% and 8%. The response to Woolworths and Flight Centre’s results were also a mark of the times. With valuations high at the quality end of the market, investors are, unsurprisingly, nervous and are prepared to pay up for the appearance of certainty.
There has also been a rise in the number of companies buying back stock – James Hardie, CSL, IAG, Computershare, Ansell, Qantas (shudder), Telstra, Rio, Caltex to name just a few. Historically, this is a trend that increases as a bull market progresses but ends abruptly when share prices collapse (as counterproductive as that is).
That buybacks are becoming more popular could be a sign of complacency among managements and investors. As Howard Marks once said, ‘The riskiest thing in the world is the belief that there is no risk’.
Note: Our detailed Reporting Season Wrap Special Report is now in production and will be available to members this week (fingers crossed).
Note: The Intelligent Investor Growth Portfolio and Equity Income portfolios own shares in many of the stocks mentioned. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.
Disclosure: The author owns shares in Computershare and South32.