Jamie Nicol

A difficult six months in a number of sectors has led to mixed reporting of Australian listed companies, says Jamie Nicol, CIO, Dalton Nicol Reid.

“Our research shows that 36% of Australian listed companies beat market expectations and 23% of the companies missed market expectation in the current reporting season,” he said.

“It’s important to note that there is a small downgrade of around 0.8% forecast for 2015,” he said.  “Already around 28% of companies have been upgraded for 2015, and 27% downgraded.

Mr Nicol said that it has been difficult to forecast in the current economic climate.

“Offshore markets were impacted by the volatility of the weather, and domestic companies were hit by the federal budget which caused a drop in consumer confidence.”

“While analysts are reluctant to project the difficult trends to continue, they are also reluctant to forecast a large bounce,” he said.  “In a number of our holdings we see analyst’s forecasts as being quite conservative and have been adding to these positions.”

“The underlying backdrop of low yields does make companies returning capital to shareholders seem appealing in the near term, however we are concerned that this strategy is somewhat short sighted.

“We are already seeing a trend where companies with buy-backs (even if small) and special dividends were rewarded – such as Suncorp, Telstra.

“High quality businesses should be able to reinvest capital to generate even greater future returns for shareholder,” he said. “We see the trend of returning capital as somewhat counterintuitive given the current low cost of debt and equity.”

“We are concerned that while the market continues to reward near term yield over longer term growth, most company Boards will be reluctant to invest in future opportunities preferring the short term impact of returning capital.

“So we are actively seeking quality companies where Boards are prepared to reinvest in the business to generate future returns rather than taking the short term ‘sugar hit’ of returning capital – such as Aurizon & Origin Energy. “

“With top line revenue growth remaining scarce, companies with strong business models that demonstrated sustainable growth are being justifiably rewarded (eg Veda Advantage, Iress & Domino’s Pizza).

“A generally sluggish economic backdrop means companies that can generate maintainable growth are likely to continue to be rewarded by the market and we continue to investigate opportunities in this area.

Mr Nicol was optimistic about the continued expansion of domestic housing activity which has continued to expand. “Housing is now settling at a much healthier level of activity following several years of anaemic growth post GFC,” he said. “We have a solid exposure to this area and expect underlying demographics and historical underbuilding to drive returns for quality companies exposed to this sector.”

But Mr Nicol said that mining activity continued to slide with the capex peak on existing projects having passed, and new projects still struggling to get approval.

“The focus has turned to non-residential construction activity to fill the void, but despite much talk at both federal and state government levels, the long lead times and political nature of these projects means real activity is still some way off,” he said. ‘We remain optimistic that the activity levels will eventually pick up in the area and see opportunities for companies such as Lend Lease to participate.”

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Jamie Nicol

Treasury Wines has announced they have received a revised bid from KKR Rhone Industries which values it at $5.20 a share.  Treasury are now allowing KKR to enter the data room which is a condition of the bid. Dalton Nicol Reid entered the company during the past six months having met its quality criteria.

“The change to the bid represents a more reasonable reflection of the potential value of Treasury Wines.  On our estimation, at these prices a strong return remains available to KKR as they sell off assets and re-gear the company,” said Jamie Nicol, Dalton Nicol Reid Director and CIO.

“While management is now pleasingly engaging with KKR we would expect that they are continuing to consider ways to realise the value embedded in the business.  Treasury Wines can seek to extract the break-up value for shareholders and other potential buyers for the business as a whole.”

According to Mr Nicol, the US business has significant hard assets across agricultural assets and infrastructure as well as a portfolio of well-regarded brands that Dalton Nicol Reid values at close to $1bn excluding inventory.  This business includes 36 brands including Penfolds, Wynns, Lindemans, Rosemount and Wolf Blass with substantial agricultural assets and infrastructure.

“These businesses have material earnings potential and with good management execution, we see value in excess of the implied value from KKRs initial bid – albeit with a degree of uncertainty around execution.”

“The company has suffered from neglect, poor management and a cyclical downturn.  Australian vineyard production had doubled from the late 90’s creating a grape glut. This was a global trend, which is now starting to ease following a number of years where uneconomic producers have exited the market and with demand picking up in China and the US.   However in the past year Treasury Wines has also suffered a number of short term profit issues, including a crack-down on gift giving in China, an inventory issue in the US and a poor promotional performance over Christmas in Australia.”

Mr Nicol said he believed the market has been too short term focused on this company.

“The market has been focused on the current poor profit performance and if you apply a multiple to these distressed earnings, then a valuation is indeed difficult to justify.   However, we prefer to take a medium term view of a company such as Treasury Wines and are interested in the quality of the underlying brands such as Penfold’s.  We also like the strong balance sheet including long term inventory, which enables investment to drive stronger profit growth in the future.”

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Jamie Nicol

Dalton Nicol Reid has released a statement on the bid from private equity firm KKR for Treasury Wines.   KKR has made a conditional bid for Treasury Wines at $4.70 a share, surprising many in the market.  Dalton Nicol Reid entered the company during the past six months having met its quality criteria.

Jamie Nicol, Dalton Nicol Reid Director and CIO, said there is some caution from analysts regarding the amount that KKR will be prepared to pay for the company, however the value of the business should not be underestimated.

“The company has suffered from neglect, poor management and a cyclical downturn.  Australian vineyard production had doubled from the late 90’s creating a grape glut. This was a global trend, which is now starting to ease following a number of years where uneconomic producers have exited the market and with demand picking up in China and the US.   However in the past year Treasury Wines has also suffered a number of short term profit issues, including a crack-down on gift giving in China, an inventory issue in the US and a poor promotional performance over Christmas in Australia.”

Mr Nicol said he believed the market has been too short term focused on this company.  “The market is focused on the current poor profit performance and if you apply a multiple to these distressed earnings, then a valuation is indeed difficult to justify. However, we prefer to take a medium term view of a company such as Treasury Wines and are interested in the quality of the underlying brands such as Penfold’s.  We also like the strong balance sheet including long term inventory, which enables investment to drive stronger profit growth in the future.”

“We have no doubt KKR will be looking at the asset value underpinning Treasure Wines and will be considering the value that can be extracted via a breakup and regearing strategy.  In this regard, we see substantial upside for the owners of the business.”

According to Mr Nicol, the US business has significant hard assets across agricultural assets and infrastructure as well as a portfolio of well-regarded brands that Dalton Nicol Reid values at close to $1bn excluding inventory.

“This along with $2bn in realisable inventory means at $4.70 per share, KKR would be buying the entire Australian and New Zealand business for under $400m.  This business includes 36 brands including Penfolds, Wynns, Lindemans, Rosemount and Wolf Blass with substantial agricultural assets and infrastructure.  These businesses have material earnings potential and with good management execution, we see value well in excess of the implied value from KKRs initial bid.”

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• Mild drag on growth—the Budget looks for a substantial shrinking of the deficit—from 3.1% of GDP in the current year, to 1.8% in 2014–15 and 1.0% in 2015–16. But this is only a mild ramp-up of policy tightening (0.1% of GDP in 2014–15, 0.3% in 2015–16) compared to what had already been laid out. While there is indeed a range of new savings measures in the Budget, a lot of this is offset by new ‘spending’ (on both the revenue and expenditure sides).

• Lower household income—a budget repair levy, changes to Family Tax Benefits, fewer benefits to job-seekers, the reintroduction of fuel excise indexation, a range of other initiatives spanning medical and senior citizens and an increase in higher education costs will all play a part in reducing household income. While these changes are more a 2015­–16 story than 2014–15, the sum of the above changes is roughly 1% of household consumption in 2013, a sizeable figure. Thus, it is expected to have an impact on consumer sentiment and spending.

• RBA required to support economy—the pressure on the RBA to increase interest rates will ease with this budget as it provides support for housing.

• Repeal the resources tax and the carbon tax—if this is achieved, it would deliver a mild boost for miners, and for carbon-emitting companies (e.g. steel, building materials, transport). It should be noted that all of the above measures will need Senate approval, which may not be straight-forward.

• Paid parental leave and a tax cut from small companies—the paid parental leave scheme will put some money back in consumers’ pockets. It is to be funded by a 1.5% levy on the profits on large companies. At the same time, the Government will lower the corporate tax rate by 1.5%, leaving the overall tax rate unchanged for large companies. Smaller companies thus enjoy a tax break.

• Lifting infrastructure spend—a combination of new funding and an asset recycling initiative (to encourage states to sell assets and reinvest) is expected to lift infrastructure spend by over $600m in 2014–15, and ~$1.5bn in subsequent years. This could provide support for contractors and building material companies.

Impact on the market

The tough budget was well flagged so it is likely that is has been absorbed by the market at this point and market action would suggest this is the case. From our portfolio perspective we see the infrastructure spend as having a positive impact on Lend Lease and Macquarie Bank, the likely impact on interest rates as being favourable for Stocklands and Dulux and the changes to the Medicare co-payments having a negative impact on Sonic Healthcare (albeit we do not think the impact will be substantial).

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Dalton Nicol Reid has announced the appointment of Robert White as its new Chief Executive Officer and Head of Distribution.

Jamie Nicol, Director and CIO said the new appointment was a positive step and that it would allow the business to continue on its current growth trajectory.

“Dalton Nicol Reid has passed some significant milestones lately.  In the last six months, we have secured two institutional mandates, our funds under management has reached $850m and we have broadened both our investor and shareholder bases.  We also bid farewell to our former CEO and one of our founders, Harley Dalton.”

“We are delighted to now announce that Robert White will take on the role of both CEO and Head of Distribution.   We are pleased to have found such a high calibre professional with a depth of knowledge in both wealth and funds management, across a diverse client base of retail, wholesale and institutional investors.  We believe the qualities Robert brings to Dalton Nicol Reid will be a perfect fit for our business.”

Mr White has significant experience spanning nearly 20 years in the financial services industry gained through working in the United Kingdom, Europe and Australia. Most recently he was Executive Director and Head of Advice at JBWere Private Wealth Management.  Prior to that, Mr White was Joint Managing Director and Chief Executive Officer for HFA Asset Management (now Certitude Global Investments) where he and his team delivered the strategy that saw the business grow funds under management from $80m in 2003 to $4b in 2008 and successfully navigated the business through the GFC.

Mr White will take up his new post effective 24 March.

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Dalton Nicol Reid received a “Recommended SMA ”rating from Lonsec.

Independent Australian investment management company Dalton Nicol Reid today announced that its Australian Equities High Conviction Portfolio has received a “Recommended ^SMA ”rating from investment research house Lonsec. The rating is an upgrade from the previous ‘Investment Grade’ rating received in March 2013.   Additionally, Praemium has included the Australian Equities High Conviction model portfolio on its SMA platform offering.

“Lonsec believes the manager (Dalton Nicol Reid) offers a robust and highly repeatable investment process that has been a proven outperformer across the investment cycle.”  In the three years to June 2013, the Model Portfolio has outperformed the Lonsec benchmark by 3.97% per annum before fees. Shorter-term performance has also been strong with the Model Portfolio outperforming the Lonsec benchmark by 5.38% for the year ended June 2013.

According to Lonsec, “Dalton Nicol Reid has many of the attributes it looks for in boutique managers, including a performance-driven culture and a strong alignment of interests between staff, investors and the firm”.

Lonsec also described Chief Investment Officer Jamie Nicol as an “astute and experienced investment professional” while his key Portfolio Manager Scott Bender is credited as being “a quality investment professional who has built a successful track record working alongside Nicol.”

Commenting on the rating, Dalton Nicol Reid CEO Harley Dalton said, “We are pleased to have received this rating, which reflects the team’s considerable experience in the SMA space and clear focus on consistently outperforming the market.”

The release of the Lonsec “Recommended ^SMA ” rating comes shortly after Praemium included the Dalton Nicol Reid Australian Equities High Conviction model portfolio on its SMA platform. Praemium Commercial Director Andrew Varlamos said Praemium has an open architecture business model and encourages the addition of quality boutique managers to its offering.

“Dalton Nicol Reid has been a pioneer in the SMA sector and has built a considerable following amongst advisers seeking to give their clients transparent portfolios.  We are very pleased to add Dalton Nicol Reid models to our platform,” Mr Varlamos said.

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So why is this important and why is the market selling off?

Over the past few years Hedge Funds and others have been able to make certain investments on expectation that the trends will continue. That is that QE will keep bonds yields low and that this will mean other yield orientated investments will also be attractive. These investors are now starting to unravel some of their positions which are causing an adjustment for the markets.

Implications

The implications for our market are as follows:

1. It places downward pressure on our currency as A$ bonds and high yield stocks were one of those investments that have benefited from QE. In the short term as offshore investors sell out of the Australian positions it creates some negative volatility.
2. Ultimately a pullback in the currency has positive implications for profits of the Australian market and will improve the competitive position of many companies. We estimate that at a 90 cent A$ there is a 9% positive impact to profits.
3. From a valuation perspective the Australian market has pulled back 10% so when combined with the impact of a lower currency the Australian market is nearly 20% cheaper than it was two months ago.

In addition to the QE easing the Australian market is adjusting to life after the resource boom. Some of those sectors of the economy which have done well in the past few years are likely to struggle and the RBA will be looking for other segments such as housing and non-residential construction to breathe life into the economy. A lower currency and lower interest rates will help in this regard as will an election to remove current uncertainty.

From a positioning perspective we continue to like those companies exposed to offshore earnings such as Brambles, QBE and Ansell and those companies which can benefit as money flows out of bond markets (such as QBE and Macquarie Bank). We will also be looking at opportunities that emerge from the current volatility.

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This has seen good buying support especially for the higher yielding stocks. The consequences from our perspective of a further interest rate move are as follows:

1. It will place further pressure on the A$. A pullback in the A$ would provide relief for a range of companies including those that operate offshore and those that compete with importers.
2. It will provide stimulus for the housing market given improved affordability and be helpful for other domestic companies.
3. It may well encourage further interest in higher yielding stocks however we caution that these stocks are beginning to look expensive and do not seem to offer the best risk adjusted return in the market.

In other news during the week Woodside announced they will pay a special dividend and lift their payout ratio. This is likely to lift their dividend yield to 6.5%. The market liked this move and lifted the stock 10%.

While we do not see a simple lifting of a payout ratio as a creation of value, we like the fact that it signals management will be disciplined with their capital allocation and will need to justify to shareholders future decisions.

We see this step as a good road map for the new CEO’s at BHP and RIO who will be looking to make a mark. They are not in as good a position as Woodside to make this move as yet. However cost cutting and selling assets will place them in a position to do so in the coming year or so. The question is when will the market begin to buy on anticipation? This is a difficult question to answer however there is value there at present.

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Not so precious?

Markets have softened in response to two factors; these included the bombs that caused carnage during the Boston Marathon.

This occurred an hour before the close of the market and resulted in a 100 point fall. While our thoughts go out to those impacted, we would expect the impact on markets to be short lived. The other factor was continued weakness in gold (down 9%) and to a lesser extent other commodities.

We find the weakness in gold interesting. As can be seen in the chart below, gold has been a very strong asset over the past decade during much turbulence from other asset classes. It has been seen as a defence against deflation risks and a safe haven from the GFC.

With risks declining and equities improving a sell-off has begun. We note there remains many convicted gold bulls with concerns that money printing by the Fed will cause a bout of inflation.

The issue for gold is that there is a need to find even more buyers to drive the price up and after a decade of moves this has been more difficult. Furthermore, as it starts to fall investors become more conscious of the fact it does not produce any income and this is creating selling pressure in a market searching for yield.  

We see two main consequences from the gold sell off:

1. Are safe havens safe? We have seen a near bubble in perceived safety in recent years. Gold rallied, bonds rallied, and safe stocks have rallied (eg Telstra). Does a gold sell off signal that money can begin to come out of these other trades? We remain cautious of bonds but would not expect a savage sell off given Fed buying support. However we also believe the weight of money will be looking to exit these “safer” trades over the next few years and looking for investments with a better risk / return trade off.
2. Where does the money from gold go?  We do not see it as likely that money will transfer out of gold into bonds so it is likely to find its way into equities, property or infrastructure.

We do not see gold as providing much of a road map to the performance of other commodities which should run on traditional supply / demand dynamics. We have been seeing some softness in this regard and are cautious on mining service players and small miners.

However we remain positioned in the larger miners for the following reasons:

1. They are taking steps to reduce capex and cut costs and as they free up free cash flow they will increase returns to shareholders. We note we have seen Woodside cut their proposed capex on their Browse project and we expect a significant capital return from them as a result.
2. They have world class assets, low on the cost curve which means they can ride out cycles.
3. They are already priced at a discount to valuation reflecting the market cautiousness towards commodities at present. While it is difficult to identify a catalyst at present, we could envisage a turnaround on the back of further Chinese stimulus.

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ASIC has announced the review in light of the growth in the sector and to make it clear it that the investment program that forms part of the MDA contract contains an investment strategy.

Chief Executive Officer and Director, Harley Dalton, said the move would help ensure the sector remains well-regulated and would give investors surety when selecting an MDA provider.

“As an operator of MDAs for more than 10 years, we have a very deep understanding of the issues and potential pitfalls of this type of investing.  We believe that the review by ASIC will help create transparency for investors and ensure that all MDA providers are subject to the appropriate level of regulation, which will help build confidence in our markets.”

Mr Dalton said that investors had responded positively to Dalton Nicol Reid’s MDA offerings and that it remained committed to delivering strong performance to its investors.

“Our investment portfolios are frequently ranked among the top performers in their asset classes.  In the past two years, we have been increasingly focused on the adviser and institutional markets.  We are now included on most SMA platforms and we have received positive ratings from a number of research houses.

“We are very proud of this performance and look forward to further strengthening our relationships with the adviser and institutional markets.”

The Dalton Nicol Reid Australian Equity High Conviction portfolio was recently received a new rating from Lonsec, the first time the research house has rated the group.

Lonsec said Dalton Nicol Reid “offers a robust and highly repeatable investment process that has been a proven outperformer across the investment cycle. Moreover, Lonsec notes the team is highly aligned with the long term success of the Model Portfolio, with the majority of investment staff owning significant equity in the business.”

The Report also stated that Dalton Nicol Reid has a well-evolved awareness of the specific risks of running an SMA model portfolio. “To date, Lonsec believes the Manager has implemented best-practice processes and controls to mitigate these risks, albeit in a rapidly-moving area.”

Lonsec has initiated coverage of the Model Portfolio with an “Investment Grade” rating and will be looking to build growing conviction in the Manager when the Model Portfolio is reviewed “in-cycle” in the third quarter of 2013.

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