The continuing European sovereign debt crisis saw the Australian stock market trade below 4100 for most of June, still down around 10% from the highs above 4400 in early May 2012.
Euro zone – another positive step
The announcement in early July that the European Central Bank (ECB) would be permitted to make loans directly in the Euro Zone, rather than previously where such assistance had to be channelled through sovereign governments.
The reason this is important is that it opens the way for a European banking regulator to supervise the European banking system across each of the sovereign states. The removal of politicians from this process is a positive. More importantly, direct access to the ECB allows the banking system to constitute the ECB as a “lender of last resort” in much the same way the Reserve Bank of Australia acts as lender of last resort to Australian trading banks. It is the fact that the ECB has control of the printing presses and so it can simply print money to accommodate any run on the banks; the fact that this mechanism is in place means that one tends not to see runs on banks, except perhaps in isolated instances in Europe if a particular bank has individual issues.
The removal of such systemic risk is an important step in the stabilisation of the European banking system. It also means that the individual state debt and the banking debts become separate issues and can be dealt with separately.
On the fiscal front i.e. government spending, the debate has slowly moved in favour of less austerity and tailoring spending to provide a limited stimulus within an overall budget cap. This is also a positive debate for Europe.
It is not Europe as such that has an issue. It is those states across southern Europe which are grappling with high debt/GDP levels. With the exception of Greece, which your diarist has seen as a country which should not be and never have been in the Euro, the European debate has produced more positives than negatives in the last few weeks.
Robert Johnson, director of Economic Analysis with Morningstar Chicago, provided an economic briefing on the USA to Burrell advisors and research on Tuesday 19th June 2012. In both this briefing and one held some months ago, Robert considered a range of economic data in respect of the USA economy. His views are important, because so far he has called the US economy well. In a nutshell, his view is that the US economy continues to improve slowly with economic activity positive rather than negative and economic data indicating the ship has turned around and is slowly heading in the right direction. USA unemployment is a lagged indicator and housing continues to bump along the bottom but even here Robert saw a positive in the economic statistics.
Who is left to sell?
The newspaper and TV commentary has reported investors both in Australia and the USA moving from stocks to fixed interest over recent times. This move has been supported by hedge funds that have short positions on a number of resource stocks, commodities and China. In March 2009, the Burrell Bourse called the low inflection point of the Global Financial Crisis. Those that had moved away from equities generally stayed in fixed interest and missed the uptick over the next four months, which was a significant recovery indeed.
A number of the conditions which existed in March 2009 are present today in July 2012. These include;
- Cash and fixed interest has been the preferred asset class for additional savings over the past twelve months. Little new money has been invested in equities.
- Analyst valuations of leading Australian stocks are materially higher than the current market prices of those stocks, particularly the four major resource and energy companies and the four major banks.
- The negative view of the Chinese growth, particularly from London and New York is likely misplaced with the Chinese government likely to manage its growth in a responsible way, given it’s large foreign exchange reserves and lack of any external debt issues.
- The negative sentiment arising from the overly pessimistic view of China means that commodity and resource stocks are likely to rebound towards fair value.
- Once it becomes clear that Europe is able to manage its way through the current set of policy and political issues, then a short term rebound of 10-20% before Christmas 2012 could become a realistic expectation.
Be a value investor not a sentiment investor
The value of a share is equal to the present value of its future cash flows. This is what analysts are paid to do i.e. to produce reports based on estimating those cash flows and then calculating the net present values. If there is a difference between analyst valuations and market prices, then either the valuations may be based on too rosy a picture of earnings (and we have seen some of that in the last two years) or the market should over time at least recover some way towards fair value. It is your diarist’s view that value investing from this point forward is likely to produce more satisfactory returns than sentiment investing.
Professor Gordon Hewitt
Professor Gordon Hewitt is the Professor of Strategy at Glasgow University and the University of Michigan. He presented at a PWC CEO Breakfast workshop in Brisbane on the 21st June. Some of his material will form the basis for a useful discussion for our firm’s annual strategy day attended by Directors and Associates and then the annual retreat on the following Saturday, both held later this month.
One of his observations was that markets have become more reactive to winners and losers. One only has to look at the market capitalisation of Apple as compared to the market capitalisation of RIM the Canadian producer of Blackberry and Sony.
This observation reinforced the price behaviour on non-performers on the Australian stock market over the past 12-18 months. Where a company is not earning its weighted average cost of capital (WACC), valuation theory suggests the value of the stock will continue to decline. In fact what we have seen is that companies that issue downgrades or bad news are now punished severely by the market. The question is how to predict these companies in advance of market falls. If one had a fail safe answer for that, then we would need no other skill! Your diarist suggests that looking at the Burrell research (page two of research reports shows key financial metrics), is a good habit of investing, particularly the return on equity (ROE) number. If the return on equity is less than 10%, then one requires a convincing story of recovery to remain a holder of the stock. In fact recent experience suggests that 12% is a better ROE target as it allows an investor to pick up the trend of a fall from 12 to 10% where as a fall from 10 to 8% is probably too late an indicator.
On 20th June, John Nesbitt, Group CFO Suncorp visited our offices to review the strategy update for Suncorp. Advisors gained the clear impression of a business that has implemented well major systems consolidations as per its branding “ONE COMPANY MANY BRANDS”. The stock market has priced Suncorp to punish it for the sins of 2007 when it faced a crisis due to bad banking loans during the gfc.
Suncorp management paint a convincing picture of dealing with these legacy issues, of changing the culture & simplifying the business and making the most of including flood insurance as standard.
Probably the key issue in considering whether to buy the stock is the upside now if a normal weather year transpires. With a drier weather outlook after three abnormally wet years, Suncorp could make in excess of $1b in profits once again.
With the stock cum a likely special dividend to return a portion of excess capital, accumulation of Suncorp around current levels is recommended.
Burrell advisors have much value to add to client portfolios by talking around these issues of asset allocation and stock selection.
If you would like to further discuss, feel free to leave a comment or email firstname.lastname@example.org.
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This document contains general securities advice only. In accordance with Section 949A of the Corporations Act, in preparing this document, Burrell Stockbroking did not take into account the investment objectives, financial situation and particular needs (‘relevant personal circumstances’) of any particular person. Accordingly, before acting on any advice contained in this document you should assess whether the advice is appropriate in the light of your own relevant personal circumstances or contact your Burrell Stockbroking advisor.
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