Retail trade grew by 0.1% in May to stand at a lacklustre 2.3% higher through the year.

Retail spending subdued

Retail trade rose by 0.1% in May, which was slightly less than market expectations which centred on a rise of 0.3% {CBA (f) +1.0%}. The result was made more disappointing by downward revisions to March and April’s figures (for example, April was revised down to a decrease of 0.1% over the month from a previously reported increase of 0.2%). Spending is growing at a subdued 2.3% in annual terms, which is below trend.

The retail sector has had a mixed 2013, so far. Spending was up solidly in the few two months of the year, but has since tapered off. In particular, sales over the last few months have been sedate. Some of the recent retail trade outcomes are reflecting the divergence between the real and nominal economies. Over the first quarter of 2013, real retail trade was growing at a faster rate than nominal sales, which is rare. The divergence was reflecting discounting in some parts of the retail sector, particularly the household good retailing category which largely comprises imported goods. These goods have been made cheaper by a strong Aussie dollar. But the currency has depreciated by around 10% since its peak over the last two months, so we are unlikely to see the divergence between nominal and real outcomes continue.

Over May, retail trade was strongest in department stores (+0.8%) and other* (+0.8%). This was followed by clothing, footwear and personal accessory retailing (+0.4%) and food retailing (+0.2%). There were falls in household goods (‑0.3%) and cafes, restaurants and takeaway food services (‑0.6%).

On a State basis, the results were mixed. There were increases in WA (+1.6%), NT (+0.8), SA (+0.6%), Tas (+0.6%) and Qld (+0.5). The two largest States, NSW and Victoria, both recorded a fall in retail trade over May. Sales were down by 0.4% in NSW and 0.3% in Victoria. Retail trade also declined in ACT (‑1.7%).

The consumer spending story has been a mixed one. The broader picture is that while consumers are spending, they are selective with where they spend their money. And retailing has been missing out. In particular, the retail sector has had to compete against consumers spending a greater proportion of their disposable income on overseas holidays, which have been made cheaper by a strong Aussie dollar. But the outlook is more positive for the local retail sector. The non‑trivial 10% fall in the Australian dollar makes overseas holidays less attractive. And it also means purchasing online from international retailers is more expensive. Both of these shifts in relative prices support domestic retail trade. In addition, household disposable income has been boosted from interest rate cuts. These take some time to work their way through the economy with some mileage still to come from the most recent rate cuts.

The CBA Business Sales Indicator, which is a broader measure of consumer spending than retail trade data, recorded its strongest monthly percentage increase in five years in May. This suggests that consumer spending is running at a more robust pace than what the retail trade data indicate.

The HIA new home sales figures for May were also published today. New homes sales increased by 1.6% in May, which took sales back to their highest level in eighteen months. So while the effects of lower interest rates are not showing up in the retail trade data, the latest home sales figures suggest that lower rates are having a positive effect on the housing market. The RP Data‑Riskmark house prices data out this week, which showed dwelling prices rose by 1.9% in June, is further evidence of the impact that monetary policy stimulus is having on housing activity. Increased construction activity and a positive wealth effect will eventually spill over to the retail trade sector.

*other retailing includes newspaper and book retailing, recreational goods retailing and pharmaceutical, and cosmetic and toiletry goods retailing.

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The nice surprises are going to come from the mining companies in line with higher commodity prices while the nasty surprises will most likely come from the retail sector. Companies leveraged to the US recovery such as News Corp and Westfield will be ones to keep an eye on as they should show continued bottom line improvements, according to CMC Markets’ Market Analyst Ben Le Brun.

His predictions and tips are summarized below:

Increased dividends for miners as emerging markets drive commodity prices

• Emerging markets and improved global economic conditions should continue driving commodities prices, leading to plenty of upside for mining companies. Fears continue about the impact of tighter monetary policy in China, but remember any tightening makes their growth more sustainable.
• Excitement is building around BHP and Rio Tinto as share buy backs and increased dividends look more likely. Investors love increased dividends and if this takes shape I expect further upside in both stocks.

Watch retailers for real revenue growth

• Danger looms for a few retailers and some have already issued profit warnings eg Woolworths. It is a case of whether fund managers have been pessimistic enough on stocks that have been sold down lately. Softer consumer spending is an ongoing issue, coupled with weaker than expected Christmas sales.
• Look at a company like JB Hi Fi. Although their earnings were average, the stock price rallied after their figures were announced, as it appeared analysts had over shot the mark in terms of pessimism.
• Look for revenue verses earnings per share when dissecting results as you need to be wary of improved operations through cost saving – it does nothing to increase sales, which is what the market really wants to see.
• It will be just as important to analyse futures earnings guidance and current market conditions as well as the headline figures – consumer spending in Australia is expected to remain soft.

Don’t forget flood damage

• Most of the damage from the QLD floods has been documented now and it is time for some companies to confess how badly it has hurt their bottom lines. Theoretically this should have already been priced in, although we will see whether it actually has. All eyes will be on companies such as Suncorp, whose results will put a tangible number on how the floods have actually impacted companies bottom lines.

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The big picture

• Next week the Reserve Bank is widely expected to lift interest rates. Interestingly if you go back just over a
  fortnight ago no major forecaster was expecting a rate increase in October, believing that the Reserve Bank
  would want to see the September quarter inflation figures first (released October 27). But that was before a widely respected economic journalist indicated that rates were likely to lift on October 5. Oh, the Reserve Bank Governor also delivered a speech and Reserve Bank Board minutes were released. But there was little new in either.
• So what gives – why are rates poised to rise? (Note we say ‘poised to rise’ – a rate hike is by no means a certainty.) It all gets down to strategy. If the Reserve Bank was to wait, the September quarter inflation figures may actually be favourable. That would make it more difficult for the Reserve Bank to justify a rate hike.
• Now I know there would be some rubbing of eyes at this point. Doesn’t the Reserve Bank want ‘good’ inflation data – that is underlying inflation between 2-3 per cent? Clearly that is the whole point of monetary policy. Interest rates are set to ensure that inflation holds between 2-3 per cent over an economic cycle. And if the goal is achieved, surely that means that rate settings are ‘right’ – that is, rates don’t need to rise or fall.
• The problem with waiting for the next inflation figures is that this is effectively setting policy by looking backwards, not forwards. The Reserve Bank must always be forward looking. Policy settings that are put in place now affect future decisions on spending, investing and employing. The fundamental point is that the Reserve Bank believes that inflation is not going to fall further and has given hints that its previous forecasts are too optimistic. That is, to keep inflation in the target band it will have to lift rates, not leave them where they are.
• Now, it’s important to remember that these are just forecasts. The next inflation figures may surprise – they may actually be lower than Reserve Bank estimates. If that’s the case, the Bank may leave rates alone in November and December. And clearly it will have further justification to leave rates alone if retail spending remains soft. Remember the July lift in sales was all due to spending at cafes and restaurants – appears hard to believe. Also loans to build homes have fallen for an unprecedented nine months. And then there is the strong Aussie dollar, serving to keep inflation low and reduce activity in exports, manufacturing and tourism.
• At each meeting, Reserve Bank Board members always ask one fundamental question – of all the decisions that I could make, which would I regret the least. In light of what happened in 2008, Board members are worried about getting behind the curve, rather than lifting rates a tad too much. At the end of the day, the Reserve Bank has the call, and Aussies hope that it will get it right.

The week ahead

• In a strange quirk of timing, the economic cupboard is stocked full of data releases in the coming week. Of course that leaves a hole in the middle part of the month, but that is an issue for the future.
• On Monday, the Labour Day holiday is observed in NSW, the ACT and South Australia. But other centres are open, so there is no holiday from economic data. The TD Securities/Melbourne Institute inflation gauge is released on Monday together with the Advantage job advertisement index.
• On Tuesday the Reserve Bank Board meets, retail trade, the ANZ job ad index and international trade data are released and the Australian Industry Group and Commonwealth Bank issue the Performance of Services index. On Wednesday the head of the Reserve Bank’s financial stability section, Luci Ellis, delivers a speech and tourism arrivals data is released. The monthly employment survey is released on Thursday while the Reserve Bank’s Deputy Governor, Ric Battellino, delivers a speech on Friday.
• As noted above, we think the Reserve Bank will lift rates on Tuesday. While we don’t believe that the RBA should be lifting rates – the economy is softer than it assumes and inflationary pressures are contained – it has the call.
• Of the economic data, most interest will be in retail trade and employment, despite the fact indicators are backward looking, especially employment. Actually the job advertisement data, inflation gauge and Performance of Services are probably more instructive, but all the indicators to be released over the week have their uses.
• Retail trade probably rose by 0.3 per cent in August after the surprise 0.7 per cent gain in July. All of July’s increase came from spending at cafes and restaurants, so if there is a reversal in August it could lead to a far weaker overall result for retail spending than assumed.
• A potential complication is also possible with the employment figures as election-related hiring of staff may have inflated the figures. Overall though the jobless rate is at a 19-month low of 5.12 per cent and little change is expected on that result in September. Employment probably rose by 20,000.
• Of the other data, another solid trade surplus of around $2.5 billion is expected for August.
• In the US, the spotlight will again shine brightly on the non-farm payrolls (employment) data, released on Friday. Again, as we noted for the Australian employment data, this indicator is backward looking. Still, in the US, concerns about a ‘double dip’ recession centre on the health of the job market. So there is no escaping the focus. Still, the ADP employment index (Wednesday) and weekly jobless claims data (Thursday) must also be watched closely for the same reason.
• Economists expect that private sector payrolls rose by 75,000 in September after the 67,000 increase in jobs in August. While the modest size of the job gains will be bemoaned, it is important to note that employment is actually lifting a lot earlier than in the post-2000 recession. The unemployment rate probably edged higher from 9.6 per cent to 9.7 per cent as discouraged workers start to look for work again.
• Of the other data, factory orders and pending home sales are released on Monday. On Tuesday the ISM services index is issued and consumer credit figures are slated for Thursday. And wholesale inventories data is released on Friday although it will clearly take a back seat to non-farm payrolls.
• Economists tip mixed results with factory orders down 0.3 per cent in August, the ISM services index up from 51.5 to 52.2, the ADP employment index up by 18,000 and consumer credit down US$3 billion.
  

  Sharemarket

• The US earnings (profit reporting) season begins on Thursday. Alcoa traditionally kicks off the reporting season
  and again that is the case. However given the focus on financial, technology, retail and home building stocks,
  Alcoa’s result (7 cents per share expected) is hardly a bellwether for the US corporate sector as a whole. Alcoa
  will be followed by the likes of Intel, JP Morgan, Google and General Electric in the following week.
• Domestically the focus again will be on the so-called “annual general meeting” season. A range of issues will dominate these meetings such as guidance on dividends and future earnings, information on how companies are tracking in the new financial year and executive remuneration issues.

Interest rates, currencies & commodities

• As we noted last week, our currency strategists have changed their forecasts. This follows the broader reassessment of our economic assumptions and changes in financial market pricing. It now appears that the US Federal Reserve won’t be in a position to lift rates until the second half of 2011. And the European Central Bank and Bank of England may stay on the sidelines for the entire year. At the same time China will expand at a near 9 per cent annual rate and our Reserve Bank will tighten policy to keep the economy on the straight and narrow.
• We now believe that the Aussie dollar will end the year at US97 cents and that it will lift further to US$1.02 by the
  end of March 2011. However the Aussie is expected to ease to US94 cents in September 2011 and US92 cents in December 2011 as the US Federal Reserve starts lifting rates from emergency levels. The Aussie is also tipped to lose some ground against Pound Sterling in late 2011 to around 57 pence. But with low interest rates likely to be necessary in the Euro zone for longer, the Aussie is expected to end 2011 near 75 Euro cents.

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• Australian retailers, especially those dependent on seasonal purchases, could face new pressures unless the weather starts to warm up in the next few weeks. Capital cities such as Sydney, Melbourne and Adelaide are experiencing their coldest starts to spring for over a decade.
• Simply, consumers are unlikely to update their spring/summer wardrobes until the weather starts to warm up. And if temperatures remain mild, this will further hinder purchases of goods like electric fans, air conditioners, outside furniture and beach equipment.
• Retailers are already under pressure from conservative consumers with both David Jones and Myer still heavily discounting hard-to-shift stock.

Click here to download the document (pdf)

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• Tentative signs of a recovery in consumer spending. A key gauge of economy-wide spending posted its strongest result in nine months in August. The Commonwealth Bank Business Sales Indicator (BSI) rose by 0.1 per cent in the month, the first positive reading since November last year.
• The Commonwealth BSI is obtained by tracking the value of credit and debit card transactions processed through Commonwealth Bank merchant facilities.

Click here to download this article (pdf)

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• In percentage terms, employment in the mining sector expanded rapidly over the past year. In the year to August, mining sector employment grew by 33,000 workers or 20 per cent, significantly outperforming other sectors.
• Over the three months to August, employment across Australia grew by 78,500 or 0.7 per cent – well above the 10-year average job growth of 56,000.
• The biggest industry in terms of employment remains health care and social assistance. And the health care sector led the job gains, with employment lifting by 45,200.
• Across the states NSW (+28,100) led the job gains in the three months to August, followed by Victoria (+13,800), and Western Australia (+12,600). Virtually all the job losses occurred in Queensland (-22,200).
• The Reserve Bank Assistant Governor Philip Lowe has highlighted the concerns about the “relatively limited amount of spare capacity in the economy” and the resulting threat of inflation.
• In seasonally adjusted terms imports fell by 6 per cent in August. The slide in imports suggests that the recent spell of trade surpluses should continue.

Click here to download the document (pdf)

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Decisions by investors to buy, sell or hold assets are based on a comparison of the price being asked with the investor’s idea about what the asset is worth.

There are many different ways to investigate what an asset might be worth. A property, for example, might be valued by looking at comparative recent sales, by adding development costs to an estimate of the land value, by discounting future income returns from the property and so on. Often it is wise to use a variety of methods and to be cautious if there is a wide difference between the lowest and highest.

Irrational valuation

Some conclusions about value are drawn rationally, but many are not. On the irrational side, perhaps the most common fallacy is what behavioural economists call “anchoring”; the tendency to derive a number by using another irrelevant but readily available number as a reference point (the “anchor”).

Retailers make good use of this tendency to anchor when they advertise reduced prices in sales. Good merchandising demands that the old price, often crossed out, should appear on price tags as well as the new, lower one. A rational buyer will disregard the old price completely, of course, and only consider whether the new price represents good value for money, but marketers are able to rely on the fact that many customers will anchor on the old, higher price, and conclude, perhaps subconsciously, that the new price represents value that might not exist.

Similarly, anchoring may cause an investor to think that a share that has dropped in price is good value (or vice versa) without much more investigation. If the previous price is used as an anchor, the tendency is to think that a price that is low compared with yesterday’s price is a price that is low compared with “good value”, but that might not be the case at all. The fact that a price has fallen does not mean that it can be expected to return to its previous level at some point. As we know, stocks do not always return to their previous prices. Some continue to fall, and some go into liquidation, disappearing altogether. The price fall has probably occurred for a reason, which usually means that all previous prices, calculated before the change in circumstances, will be out of date and of no relevance. Market participants are re-assessing the intrinsic values of companies continuously, and a well advised investor will also be trying to measure prices against assessments of value which incorporate the most up to date information available. Yesterday’s calculations and prices are of little relevance.

Incidentally, there is evidence that even hard-nosed professional market analysts are not immune to the intrusion of bias and irrationality when assessing value. To a certain extent, that is the reason for the existence of quant programs. By leaving the decisions to computer models, the possibility of human bias is claimed to be removed

Traditional valuation methods

The valuation of listed shares is of particular interest to financial planners, who advise on long term needs, and try to optimise the balance between the investment, longevity and inflation risks that clients face. A large range of financial ratios is available from brokers’ web sites, or in company financial reports, that can help in forming a rational view of the value of a company. These include profitability ratios (eg ROE), liquidity ratios (eg quick ratio), capital adequacy ratios (eg gearing ratio), market ratios (eg P/E), management efficiency ratios (eg debtor turnover) and the bankruptcy predictor, the Altman Z score.

While all these measures can provide valuable insights into a company’s worth, they suffer from the problem that they are mostly derived from past events on a short-term basis while the true values of companies emerge from future events over the long-term.

Of course, the future is unpredictable, but to help to deal with this, in recent years a new measure of company performance has emerged; Economic Value Added.

Economic Value Added (EVA)

EVA measures the difference between the return on a company’s capital and the cost of that capital. In practical terms, EVA is calculated by reducing Net Operating Profits After Taxes (NOPAT) by the total cost of capital, including both debt and equity capital. A positive EVA indicates that value has been created for the owners of the company. Conversely, a negative EVA indicates the destruction of shareholder value.

To see the difference between EVA and more traditional performance measures like net income, take the example of a newly established company called Allen’s After-market Accessories (AAA). The company earns $1,200,000 on a capital base of $10 million thanks to the success of a single imported product line. Traditional accounting would show that AAA offers an above average return on capital of 12%.

However, AAA has only been operating for a short time, and the reliance on a single product line carries significant risk. The lenders to such an enterprise will no doubt charge premium interest rates, and owners will also be looking for higher than average returns. If we assume that in combination these lenders and investors expect 15%, then the EVA calculation will show a loss of value of 3%. So although AAA reports an accounting profit, it has not met the requirements of the providers of capital, and the result has been a reduction in shareholder value.

On the other hand, if AAA were less risky and better established with a cost of capital of 10%, then the same first year operating result would have produced surplus income equal to 2% of capital. That amount would represent an addition to the company’s economic value.

Another way to look at this measure is to consider that the shareholders charge the company rent for tying up their cash to support operations. EVA captures this hidden, opportunity cost of capital that conventional measures miss.

Incidentally, astute readers will notice similarities between this idea of EVA and the controversial “resource rent tax” which initially sought to tax economic “rents”; defined as earnings beyond the risk-free cost of capital.

Calculating EVA

Four steps are involved in calculating EVA. Note that these steps appear to be quite straightforward, but the items on income statements and balance sheets will have been calculated in accordance with traditional accounting standards and methods, and will require many adjustments to achieve a “pure” calculation of EVA.
Step 1: Calculate NOPAT (Net Operating Profits After Tax)
Gross Profits (Sales – Cost of Goods Sold) less Depreciation & Amortisation less Tax.
Step 2: Determine Total Capital Deployed
Net Working Capital + Net Fixed Assets.
Step 3: Calculate WACC (Weighted Average Cost of Capital)
The WACC calculation will take account of the company’s capital structure (proportion of debt and equity on the balance sheet), volatility, and the market risk premium.
Step 4: Calculate Capital Charge to NOPAT & EVA
Total Capital Deployed (Step 2) x Weighted Average Cost of Capital (Step 3)
Economic Value Added will be NOPAT less the Capital Charge.

EVA should help to identify good investments, if calculated consistently. Companies with high EVAs should outperform those with low or negative EVAs over time.

Eva momentum ratio

Arguably, the actual EVA levels matter less than changes in those levels. A positive EVA that is expected to become less positive may be a selling signal, just as a negative EVA that is expected to rise into a positive territory may indicate a “buy”.

The EVA Momentum Ratio compares changes in EVA in a given period to sales in the prior period; in other words, it provides a size adjusted measure of change in EV. For example, if EVA moves from $ 1 million to $ 1.1 million in consecutive years, then EVA in the second period is up by $100,000. If sales in the first period were $5 million, that gives us an EVA Momentum Ratio of 2% ($ 5 million divided by $100,000).

The EVA Momentum Ratio is straightforward and easy to read, yet has many advantages over other common means of establishing value.

• It consolidates earnings and assets into a single score and automatically corrects for many accounting anomalies in the process
• It is one of the few measures where an increase is unambiguously a “good thing”. For example, an improved ROC might point to underinvestment in research and development
• It is scale neutral, enabling comparisons to be made of businesses (or business units) of differing sizes.
• It is a relative measure of improvement, so will not be distorted when comparing companies starting with a strong platform of brands or infrastructure with others.
• It is a leading measure, showing improvements or deterioration in shareholder value before the traditional accounts log the profits or losses.
• It is market calibrated, automatically adjusting for risk, and measuring always against the owners’ expectations.
• It is difficult to manipulate, as the rules surrounding EVA tend to remove many of the distortions that are embedded in financial statements

It is the job of the management of a business to increase shareholder wealth and EVA is an excellent metric to add to the other indicators of financial performance. Everyone involved in advising on investment in business enterprises should be conversant with EVA.

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