Despite our reduced exposure to equities the portfolio benefited from a recovery in two of our bigger holdings- PGC and Tower Australia (both +8%) while our largest holding, Restaurant Brands, continued on its upward path (+5%).
The rally in Australia and New Zealand was partly attributable to the loose "synchronisation" of global equity markets as the US went through a stronger than expected reporting season and Europe benefited from positive results on the stress testing of its banks. The quality of the tests and their results can be gauged from a methodology which ordained, inter alia, "long-term" holdings of sovereign debt to be riskless and therefore they were not marked to market while the holdings of the same securities in their trading books (a much smaller exposure) were marked to market.
While the strength in global markets was at least partially attributable to the factors mentioned above we believe it was also symptomatic of the schizophrenic nature of markets currently. If central banks keep interest rates low enough for long enough and the monetary spigots fully open there will always be recurrent outbreaks of risk appetite followed by periods of risk aversion as investors focus on the reasons for this unprecedented central bank behaviour.
Ironically, the month was rich with profit downgrades out of Australia- particularly from domestically focussed businesses such as retailers, transport operators and service companies- which shows that the Lucky country is currently struggling to take a trick in business as well as on the rugby field.
Australia is lapping a period of significant government stimulus, and combined with consumer and corporate caution re discretionary spending and capex, is seeing a generally weak demand environment. Analysts’ optimistic recovery scenarios for 2011 are also being wound back.
Whilst markets forgot their fears during July the factors which have harried markets all year have not gone away, indeed the evidence continues to mount.
Namely -- the prospect of sovereign debt default out of Europe, the effect of government austerity measures on consumer behaviour and a lack of job growth in Western economies. This is particularly evident in the collapse of private sector credit growth in many developed economies. A June, 2010 report from the IMF noted
“After growing at an average annual rate of about 7 percent until mid-2008, bank credit growth in mature markets slowed and by the end of 2009 turned negative. Bank credit growth in 2009 dropped the most in the United Kingdom—by about 20 percent. In the United States, by early 2010 credit had fallen by almost 10 percent year on year. The euro area followed a similar trend.”
The following table shows the % of household disposable income saved for a variety of countries before and during the GFC – source UBS
| COUNTRY |
2005 |
2007 |
2009 |
| United States |
1.4% |
2.1% |
5.9% |
| United Kingdom |
3.9% |
2.6% |
7.0% |
| Spain |
11.3% |
10.7% |
20.9% |
| Germany |
10.5% |
10.7% |
11.3% |
| Australia |
0.0% |
1.4% |
5.3% |
The collapse in private sector credit and growth in household savings ratios are really just the opposite sides of the same coin but we find it difficult to reconcile with an imminent upturn in consumer demand in the developed world.
The Wells Fargo/Gallup small business index confidence in America fell 17 points to -28 in July, the lowest level the index has ever exhibited since its inception in 2003. Given the importance of small business to employment growth in the US these results back up the view that there will be close to no job growth in the US in the coming year even if the statistics suggest that the economy is in recovery. The large cap stocks, which tend to be global brands like Apple, Intel, Coke etc , which have been reporting strong numbers all have one thing in common- a declining percentage of employees in the US relative to the rest of the world.
We continue to believe that New Zealand's and Australia's links with Asia combined with reasonably strong government debt and fiscal positions will result in the Antipodean currencies remaining resilient against the major US and European units. Thus, our investments will continue to be limited to either side of the Tasman Sea.
Over the course of July we reduced three of our core positions in RBD, PGC and TPI. Reducing overall equity exposure will always entail some tough decisions and our residual exposure to these companies remains significant.
In the case of PGC we are totally supportive of the strategic direction the company has announced for Marac and impressed by the successful growth of the Torchlight Fund. However, we are mindful of the costs which will have been incurred in working towards the Heartland Bank objective and have been disappointed by the lack of news on progress within Perpetual Asset Management. Overall, we felt we would like room to average down in the event that the result due at the end of August disappoints the market.
With TPI we concluded that it was prudent to reduce our exposure to the combination of head shares and reset securities in proportion to our overall reduction in equity exposure. We elected to retain the reset securities which we felt offered better reward for risk but so far the market has done nothing to vindicate this judgement as the resets have slipped back marginally while the head shares have rallied. Fortunately our exposure to the head shares still ranks at number 11 in our weightings so we have benefited from their appreciation.
In the case of Restaurant Brands we sold a tiny number but it remains our highest conviction view. The KFC business within RBD has proved itself to be extremely recession proof and, despite paying a franchise fee based on turnover, profitability as measured by either percentage of sales or, more importantly, return on capital is still superior to most. The eventual exit from Pizza Hut will release capital, improve earnings and possibly make the company a takeover target. Added to that, the management team is kicking goals with both feet, resulting in a continuous stream of earnings upgrades. The most recent of these was announced at their recent AGM and if history is any guide their NPAT for the year will be at or above $26 million-the top end of guidance. Even after the stellar share market performance of last year this would still leave the company trading on the lowest PE of significant retailers in the Australasian market- bizarre when one contemplates the risk relative to apparel retail as exemplified by the recent Kathmandu and Premier Investments downgrades.
The overall reduction in equity exposure during the month does not mean we have been completely bereft of ideas for new investment. Since our last newsletter we have also added materially to positions in Rakon and Skellerup which now both sit just below our top 10 holdings. We expect them to be core holdings for some time and will amplify on our reasons in a future newsletter.
The constant quest for new investment opportunities is given greater urgency by the dearth of attractive options to enhance the yield on our cash. This highlights another issue which worries us. Bond markets, which tend to be less volatile than equity markets, are behaving as though deflation and recession are more imminent and certain threats than the global recovery which equity markets are forecasting. Bond yields, despite the certainty of massive future issuance and nagging fears of sovereign defaults, are at or near record lows across the developed world.
We are confident that we will keep finding new investment ideas but it will be a challenge to do so at a rate which materially affects our current conservative asset allocation stance unless either market pricing adjusts to reflect our concerns or those concerns are assuaged by improving economic news flow.
|
Top 10 Holdings as at 31 July 2010 |
| Restaurant Brands |
7.7% |
| Tower Australia |
4.6% |
| EBOS |
3.7% |
| Pyne Gould Corp |
3.7% |
| Sky TV |
3.1% |
| Cavotec |
3.0% |
| Transpacific Resets |
2.9% |
| Michael Hill |
2.8% |
| Methven |
2.3% |
| CSL |
2.1% |