Equities

With markets more unpredictable than ever, I reached out to Hugh Dive at Atlas Funds to get his view of the year ahead. In this exclusive written Q&A, he shares three key considerations for investing in 2019, and one big risk investors are underpricing.

With February reporting around the corner, Hugh discusses a stock that could surprise the market to the upside. He also shares his view on Commonwealth Bank, Wesfarmers after the Coles divestment, and his top income stock for stormy markets.

Read on to get the full story, including his summary of the last book that blew him away. 

Q1: What are three of the key considerations for investing in 2019 

We see that the three key considerations for investing in 2019 are likely to be; 

1: The impact of the Royal Commission on financial service

The last two years have been tough for the banks and financial companies that constitute a large portion of the ASX. In 2017 we saw the major bank levy (which was substantially recovered via repricing of the banks’ loan book) and in 2018, the Financial Services Royal Commission has exposed questionable lending practices and conflicts of interest inherent to a vertically integrated model of financial advice.

One of the more significant considerations for investors in 2019 will be what the Commission actually recommends. Recommendations are likely to centre around changes to legislation governing the banking, financial advice and insurance sectors.

Looking at the banks, we see the potential for a relief rally, as the bark of the Royal Commission turns out to be worse than its bite. Additionally, Commissioner Hayne is aware of the cooling of the housing market over 2018 and is likely unwilling to release a draconian set of recommendations that push the Australian economy into recession.

2: Rising rates

When speaking with clients one of the main concerns is the impact of rising interest rates and their impact on both asset prices and consumer spending. Rising interest rates reduce the valuations of companies with hard assets and the debt service costs of highly geared companies.  

Looking ahead into 2019 we see that the trajectory of rate rises will be more modest than what was expected 12 months ago. Indeed, falling house prices over the past year have raised the possibility of a rate cut by the RBA in late 2019. Though borrowers may not see much of a change to their mortgage rates, with the banks likely to use declining funding costs to offset increased compliance expenses imposed by the Royal Commission.

While the banks may escape with a rap over the knuckles, it is unlikely that AMP and IOOF will face a set of benign recommendations in the final report of the Royal Commission.

3: Changing Political landscape

In 2019 we are likely to see a change of government at the Federal level, with the Labor opposition presenting a range of policies that are likely to have negative impacts on investors in 2019. While Labor policies towards negative gearing, franking and capital gains tax are unpopular with investors; one has to commend Labor for being upfront and transparent with their plans.

In 2019 we have already seen some companies announce special dividends and share buy-backs to reduce their franking account balance in anticipation of a change of government and we expect this to increase over the next six months.  Changing policies towards negative gearing is likely to increase the downward pressure on house prices, as well as the share prices of companies that are exposed to the housing cycle such as Boral and Mirvac.  We have been increasing our exposure to companies whose activities are located outside Australia to insulate the portfolio against the spectre of further changes to long-standing government policies towards investors. 

Q2: We recently ran a survey with Livewire’s readers, and there was a surprising amount of bullishness on CBA. Can you share your thoughts on CBA’s prospects for CY19? 

I was surprised that CBA was Livewire’s 8th most tipped stock for 2019, as investors in the banks had a tough 2018 and the outlook for 2019 is far from clear. The prevailing narrative towards CBA has been a negative one, dominated by concerns about the Royal Commission, house prices and exciting fintech companies displacing the banks. CBA, in particular, has gone through a tough 12 months but has made some moves to clean up its business and focus on the profit engine that is Australian Retail banking services.

While unloved by the market CBA offers good value trading on a PE of 12.4x with a fully franked dividend yield of 6.3%.  The sale price received from Mitsubishi for Colonial was above our expectations and places CBA in strong capital position with the potential for $3 billion off-market buy-back to draw down excess franking credits in mid-2019.  

Q3: With February reporting also around the corner, could you nominate a stock that you think could surprise (upside or downside). 

Given its chequered history, I am somewhat reticent to go on record and nominate QBE Insurance as a stock that I think could surprise upside in the February reporting season.

Similar to CBA, QBE Insurance is a company that over the past decade has had low expectations going into reporting season, but in 2019 a few factors are working in its favour. Management has cleaned up the business, selling some of the more exotic businesses such as Argentinian workers compensation and Colombian third-party motor insurance that have caused surprise downgrades in the past. 

Over the past year premium rates have been rising globally and at the same time, rising interest rates in the US and Europe will boost returns on QBE’s US$28 billion insurance float. Falls in the Australian Dollar over the past year against the USA, Pound and Euro will provide Australian investors with a nice tailwind given the high proportion of QBE’s offshore earnings. 

Q4: Following the Coles divestment, what's your view on Wesfarmers attractiveness as an investment? Please explain your view. 

Post the spin-off of Coles and the sale of coal, Quadrant Energy and Kmart Tyre, over the past six months WES’ debt has reduced from $3.6 billion as of June 2018 to $300 million as of 31 December 2018. This level of debt is about $200m less than we were expecting and absent any major acquisition or buy-back WES is likely to be debt free in early 2019, an unusual position for the $35B market cap company. 

Post the divestment of Coles, Wesfarmers gives investors exposure to a stable, diversified stream of earnings exposed to the Australian economy primarily through hardware (Bunnings), office supplies (Officeworks), discount department stores (Target and Kmart), insurance and chemicals.  While a cooling housing market is likely to limit profit growth from Bunnings; we see that the biggest factor for investors will be the announcement of a significant off-market share buy-back in 2019, as the company is essentially debt-free with a franking account balance of $1 billion. Given this WES looks to be reasonable value with a PE of 16x and a dividend yield of 5.5%. 

Q5: What could be the top income stock to weather a stormy market this year? 

We see that SCA Property will be a solid income stock to weather stormy markets, and is a Listed Property Trust non-discretionary consumer spend namely food and liquor sales, as well as pharmacy and personal services.

During the last GFC discretionary spend on clothes and shoes declined sharply, whereas consumer spends on groceries and liquor increased as worried individuals stopped going to restaurants and started cooking at home instead.

The average lease term of almost ten years gives us a degree of confidence in forecasting earnings and that SCP’s distribution yield of 6% will be maintained, especially given the quality of SCP’s tenants. 

Q6: What is one big risk out there that you think investors are underpricing?  

The risk that investors are underpricing in 2019 is that commodity prices will continue to be strong on the back of a Chinese stimulus plan.

In 2009 and again in 2015 Australia as a country and in particular shareholders in our mining companies were rescued by massive Chinese stimulus packages, much of which went into infrastructure projects consuming resources mined in Australia.

Many of these projects (which we have seen firsthand such as palatial and empty hotel complexes in gritty steelmaking cities) were of dubious economic merit and resulted in substantial increases in government debt, but consumed large amounts of steel.

Over the past few years, the Chinese government have been pursuing a policy of reducing financial sector risk, moderating property market bubbles and transforming the key driver of economic growth from investment spending to domestic consumption.

These policies would be negated by a massive stimulus plan; which would boost both credit growth and commodity prices. Currently, in 2019, the mining stocks on the ASX are being priced based on another rescue courtesy of Chinese taxpayers which appears unlikely. 

Q7: Is there a book you have read recently that blew you away? 

A book that I have just finished reading was recently recommended to me by a very astute and thoughtful fellow investor. 'Thinking in Bets: Making Smarter Decisions When You Don't Have All the Facts' was written by Annie Duke, a poker champion. This book resonated with me, as investors like poker players, have to continually make decisions based on imperfect sets of information.  

Poker players don’t know what cards their opponents are holding and their opponent's exact state of mind when they decide to either play a hand or fold. Investors face an even greater set of uncertainties when buying or selling a company ranging from currency, changing business conditions, legislation and policy changes and actions of a company’s competitors. 

In the book Duke seeks to differentiate between the quality of the decision and the quality of the outcome, to improve the average weighted results of an investor’s decisions or bets. The initial example she uses is a play called by the Seattle Seahawks head coach in the final seconds of Super Bowl XLIX. The play called was a pass that was intercepted in the end zone, a bad outcome for Seahawks fans worldwide, but a quality decision based on its probability of success in the context of the game. 

Like all investors, I can think of several situations where the purchase of a stock looked prescient due to a surprise takeover or a factor that I had not previously considered boosted company profits, however, in hindsight, the actual quality of the initial decision was not particularly good and nor well-reasoned.

Q8: Given you invest in well-known big caps, what are some of the inefficiencies you can exploit in your market to create an edge?

Investing in large-cap stocks is always hard, as traditionally these are well-understood, thoroughly researched household names. However, as a large-cap fund manager, I am more optimistic about generating outperformance going into 2019 than I was a decade ago due to some structural changes going on in the industry that will benefit active managers.

In our opinion, the aggregate quality of investment research has been declining, mirroring the falling broking commissions paid by fund managers to stock brokers. Commissions have fallen further over the past year as Europe’s MiFID II regulations resulting in lower commissions being paid by large international fund manager in Australia. Deteriorating commissions from trading raise the importance of investment banking revenue and with it the incentive to write negative research on a company.

Additionally, in 2019, the market price is increasingly being set by institutional managers with limited understanding as to the long-term prospects of a business. Index fund managers mechanically buy and sell a company based on both its weight in the index and flow in and out of their fund.  While many active fund managers bemoan the shift towards index funds; we see this as an opportunity that will increase pricing inefficiencies in the market.

While these factors should benefit many active large-cap managers, Atlas approach investing from a slightly different direction to most fund managers. We utilise a proprietary Quality Filter Model to screen out companies that exhibit characteristics that have historically caused companies to dramatically decline in value.  

Fund managers naturally want to impress investors by telling them that they owned a particular company that was the top performer in the index, our investment philosophy places greater emphasis on avoiding the poor performers. Additionally, our focus on high income delivered now reflects our observation that the market consistently overpays for blue sky potential and overlooks the value of more certain returns on offer today.

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Comments

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Anthony Gabriel

Nice read!