Background

Australia’s demographic shift is having a significant impact on Australia’s financial markets. The search for income in a low interest rate environment has seen investors, particularly the rapidly growing self managed superannuation funds, develop a love affair with high-yielding stocks.

With bond yields expected to stay at relatively low levels, the demand for high-yielding equity strategies is likely to continue. Investing in just a handful of traditional high-yielding blue chip stocks and holding onto them, may however expose investors to greater volatility than they are prepared for. An actively managed portfolio, comprising a diversified selection of traditional and non-traditional high-yielding stocks that are continually assessed for value, can help reduce this volatility.

How has Australia’s population changed?

Over the past 100 years or so, Australia’s population structure has changed markedly. In 1911, it was a typical pyramid shape – bottom heavy with the population skewed to younger age groups. By 1961, the pyramid had widened reflecting the growth in Australia’s population, particularly in the 0-14 age bracket, reflecting the birth of the baby boomers post World War 2.

By 2004, the pyramid had changed shape altogether, particularly around the middle, with the baby boomers now aged in their 40s and 50s. By 2051, the Australian Bureau of Statistics (ABS) is projecting Australia’s population structure to be more top heavy, with people aged 80 plus representing a significant percentage of the population – more than those being born (ie 0-4 years of age).

What’s causing the change in shape?

In addition to the ageing of the baby boomers, increasing life expectancy is another contributing factor causing the shift in Australia’s demographic structure. According to the ABS, the average life expectancy for females born between 2010 and 2012 is 84.3 years of age, up from 58.8 for those born just over 100 years ago in 1910. The average life expectancy for men is 79.9, up from 55.2.

A lower fertility rate is also playing an important role. Australia’s fertility rate has fallen sharply since the early 1960s. A fertility rate of 2.0 (ie two children) is considered to be the replacement rate for the population – two children replaces two parents. Australia’s fertility rate has been below 2 since the mid-1970s.

Should we be concerned?

While the 65 plus age group as a percentage of the total population is expected to increase to 27% of the population by 2050 (from 15% currently), of greater economic significance is the forecast decline in Australia’s ‘inverse dependency ratio’. The ratio of the working age population to dependents (defined as those aged less than 15 years of age and 65 plus) is expected to fall from around current levels of 2 to 1.5 by 2060.

A shrinking working age population has significant implications for the Australian economy and the share market.  An ageing population places a financial burden on the economy through higher demands on public healthcare costs and social security from retirees; while tax revenue and consumer spending is dampened due to the lower proportion of the working age population.

Japan has experienced the demographic shift already and in a more pronounced manner due to negligible immigration, persistently low fertility rates and rising life expectancy. Currently, Japan has 25% of its population aged 65 plus. Over the last several years Japanese investors have been seeking high-yielding investments around the world due to low interest rates and an ageing population seeking higher income than what is available in their own country. The Australian equity market has been a beneficiary of this demand.

What impact are SMSFs having?

The rise in grey power is impacting the Australian share market quite significantly via the growth in self managed superannuation funds (SMSFs). According to the Australian Tax Office and Credit Suisse, SMSFs received an average of around $15 billion per financial year in net inflows over the nine-year period from 2003-04 to 2011-12.

What’s concerning, is that SMSFs appear to have a distorted asset allocation with a significant bias to direct domestic equities and property.

Anecdotal evidence suggests that the direct equity exposure is limited to the big four banks and a handful of blue chip high-yielding stocks. What’s more, SMSFs are continuing to buy these stocks, regardless of value or where we are in the market cycle.

The boards of companies are becoming increasingly aware of the growth and influence of SMSFs and their increasing demand for higher dividends.

As noted above, the demographic shift will potentially lead to lower economic growth. This, together with the increasing demand for higher dividends by SMSFs could exacerbate this problem as companies feel pressured to meet their demands – at the expense of investing in their businesses.

Does this mean dividend yield strategies will continue to outperform?

This demand for high-yielding equities has obvious implications for yield-driven strategies. Over the past 12 or so years, dividend yield strategies have outperformed the broader share market by a comfortable margin.

There is a strong correlation between the change in the number of retirees and the performance of dividend yield strategies. The yellow line in the chart below shows the percentage change in retirees (with the green line representing the forecast change) and the outperformance of dividend yield strategies (blue line).  As the number of retirees has increased, dividend yield strategies have outperformed.

Sustained demand for high-yielding equities for at least the next two to three decades as the percentage change in the number of retirees continues to increase, suggests that dividend yield strategies will continue to outperform for quite some time yet.

An active, value-driven approach can help to navigate through the volatility

We would however caution against simply investing directly in a handful of well known high-yielding stocks and locking them in the bottom drawer. This is not an ideal way to invest, due to the risk that pockets of yield stocks may become more vulnerable to shocks as their valuations become stretched.

This risk is exacerbated by SMSFs, which tend to hold stocks directly in a relatively passive ‘buy and hold’ manner as well as invest in index funds and Exchange Traded Funds (ETFs).

To minimise the potential of a portfolio of yield stocks being prone to such vulnerabilities requires active analysis and continual valuation of stocks.  Well-resourced active managers, such as Nikko AM Australia, who have yield strategies but with a focus on value, is one way for investors to help navigate through this potential volatile and uncertain period. It may come as a surprise to many investors but a large portion of outperformance in our high-yield strategies has actually been derived from ‘other’ non-traditional high-yielding areas where opportunities have arisen in specific stocks, rather than the traditional high-yielding stocks.

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Disclaimer: This material was prepared and issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

Figure 3: Vale, Carajas iron ore pit (Source: Tyndall AM).

With the football World Cup recently held in Brazil, it is worth mentioning another large contributor to the Brazilian economy – iron ore.

Brazil remains the second largest seaborne supplier of iron ore to China (behind Australia) and is home to the world’s largest iron ore producer, Vale. Following a recent research trip, I believe Brazil remains crucial to the supply-demand balance in the seaborne iron ore market and will have significant ramifications for prices over the medium to long term.

Brazil is a large, high-quality iron ore supplier

Morgan Stanley estimates that Brazil will export 320 million tonnes (mt) of iron ore in 2014, of which Vale will export 265mt. What is often not mentioned when comparing Brazil to Australia, is the superior quality of Brazil’s iron ore. Average iron ore grades from Brazil are well above the benchmark 62% iron (Fe) content that is often quoted. Vale produces products with up to 66% iron content. This is in stark contrast to Australian iron producer, Fortescue Metals, which produces sub-60% iron content. The key saleable iron ore grade from Rio Tinto, who produces Australia’s highest quality iron ore, is 61% (for Pilbara Blend Fines).

A shift to a supply surplus has implications for pricing In recent years, a deficit in the supply of iron ore meant the grade differential between the various iron ore qualities did not result in any significant discounting. The adjustment to the lower iron content was made to the benchmark pricing plus an additional small penalty for the Chinese mills taking lower grade than they would otherwise like for their sinter feed (iron ore feed to the blast furnace). For the producers of low-grade products this was an excellent outcome but unsustainable.

Looking back over a longer time horizon, this has not been the case. When the market moves from a deficit of iron ore supply to a surplus, the steel mills are less willing to take a lower quality product. The lower-quality product produces more slag in steel making (and a less efficient blast furnace), requires steel mills to find higher-quality iron ore to blend and increases handling costs of iron ore as low-quality ore must be blended with a high-quality product. As a result, the small penalty that is separate from the grade adjustment has in fact been a significant penalty in the  past, as high as 30% in 2009 (as highlighted in figure 1).

Figure 1: A deficit in iron ore supply has kept the price discount low in recent years

We are now moving into a phase where the supply of iron ore has caught up with demand for iron ore. In 2014, new seaborne supply in the iron ore market will be approximately 110mt per annum. For the first time since 2008, Chinese domestic iron ore supply to steel mills will fall materially (by over 70mt). 2015 will see close to a further 100mt from both Brazil and Australia. The additional tonnes in 2014 are expected to be high-grade iron ore (60% to 66% Fe) from Rio Tinto (+50mt), Vale (+40mt) and other Brazilian producers(+20mt).Steel consumption will increase by approximately 3% in 2014from 2013 levels. Over the same period, seaborne iron ore supply will grow by 16%. The large increase in supply relative to the steel consumption increase will be balanced by the closure of high-cost production both domestically in China, but also from other non-traditional producers such as Africa and the Middle East. We believe this should provide a floor in the iron ore price of around USD 90 to 100 per tonne in 2014.

Quality not just quantity

The reason this will be a golden age for Brazilian iron ore is due to its quality. Vale produces high-quality iron ore, particularly in the northern system (region), with Vale’s Carajas project being among the best quality, large scale iron ore mines in the world. In addition, the new expansion project at Carajas, S11D,is expected to add 90mt per annum of supply by 2016. The cost of producing the S11D iron ore is a mere USD 11 per tonne (excluding freight costs), reflecting the size of the iron ore body, quality of the deposits and lower labour costs.

Compare this to Rio Tinto, which is in the mid-USD 30s per tonne (excluding freight costs) and the superior economics of the new Vale iron ore are easy to see. Adding another USD 20 per tonne for freight to China and Vale will deliver iron ore to Tianjin port for approximately USD 30 per tonne, while also receiving a premium to the 62% Fe index which will make the margin for the Vale product at almost USD 60 per tonne.

It is not just the Vale iron ore that has such great economics. A review of other iron ore producers in Brazil shows that the cost delivered to the port in Brazil for many producers is in the low USD 20s per tonne. The lack of infrastructure to load ships is preventing this production reaching the seaborne market.

Port owners are able to command over USD 20 per tonne to load a ship. Add another USD 20 per tonne for freight to China and these producers are delivering iron ore to Tianjin at USD 60 per tonne. This cost is still well below the likes of Fortescue Metals and well below some of the higher-cost mid-cap Australian producers – but above Rio Tinto and BHP.

What has held back Brazilian supply?

The question then becomes, if the economics are superior for these Brazilian projects, why have they failed to deliver net new tonnes to the seaborne market (as evidenced by figure 2)? The difficulty in delivering infrastructure solutions can never be underestimated. The junior Australian iron ore miners (those who produce less than 30 million tonnes of iron ore per year) who do not own rail or port facilities understand this challenge. This lack of infrastructure has hampered their ability to deliver tonnes to the market when prices were more favourable. Brazil suffers a similar fate. For the junior miners in Brazil, the biggest infrastructure problem they face is port access. Currently, two key companies control the major export ports for iron ore. They are Vale and Trafigura.

Figure 2: Brazil has lagged Australia in delivering supply

Vale has an incentive to keep iron ore prices supported and fill the market with their own tonnes of iron ore. They benefit from the port fees they are charging to load ships and also benefit from the slightly higher iron ore price. If they increase the port capacity, Vale will likely lower the loading fee of approximately USD 20 per tonne and will increase seaborne supply, helping to push the iron ore price lower.

Trafigura is a global trading house. By controlling supply, they can ultimately influence pricing which they rely on for their trading business. Therefore, there is not a great incentive for port expansion for non-Vale tonnes. It is this tonnage that is uncertain to come to the market by 2016 as forecast.

In addition to infrastructure challenges in Brazil, the other issue Vale has faced is environmental approvals. Carajas sits in the mountains of Northern Brazil (see figure 3). Deep in the jungle, the environmental challenges of developing mining operations has forced the government to consider the impact on the natural environment. Among the challenges are the potential destruction of caves and forest areas which affect flora and fauna. Until recently, this has been the biggest hurdle in the expansion of the S11D project.

The tide is turning for Brazil iron ore

It appears that the government is finally turning to a more favourable view on Vale expansion projects. In July 2013, the Brazilian government approved the construction of S11D, three years after the company originally expected to be granted approval. There remains one licensing hurdle to completion and the exporting of ore, and that can only be achieved once construction is complete. The recent approval shows the intent of the government to allow Vale to grow and suggests the years of frustration that have delayed production expansion (as evidenced in figure 4) may finally be over. With these tonnes, it will further reduce the need for low-quality iron ore, which suggests the low-grade iron ore produced by the Australian mid-tier miners (including Fortescue) could struggle to find a home.

Figure 4: Vale supply guidance has consistently disappointed

Increased focus on the low-grade iron ore discount

Vale has spoken of their desire to push the low-grade discount down further. They are opening a blending facility in Malaysia, with the purpose of blending their high-grade, low impurity

Carajas ore with their lower-quality, higher impurity southern system ore. The result is a product of around 64-65% iron content. The CFO of Vale recently confirmed to me during a meeting while on the research trip to Brazil, their goal is to address the company’s concern that they were not receiving a big enough premium for their high-quality iron ore (the flip side being that Fortescue was not receiving a big enough discount for their low-grade iron ore). Vale has not been happy with Chinese steel mills blending their product with lower-grade product – from Australia in particular.

It will be interesting to follow the grade discount rather than the headline price over the next six months. The big producers such as Rio Tinto, BHP Billiton and Vale have the ability to increase high-grade iron ore production and shift the mix to meet market demands and take advantage of premiums or avoid discounts. Fortescue on the other hand (and the junior iron ore miners) are more limited. It should be noted that the junior miners in a lot of cases have developed resources that BHP Billiton and Rio Tinto no longer wanted when the iron ore price was in the USD 30s per tonne. The junior minors have limited flexibility to improve grades without increasing production costs substantially.

The situation developing in Brazil will be making many Australian iron ore miners sit up and watch, and it won’t just be for the football. Brazil remains the key unknown to where prices and discounts in the iron ore market will sit. Delivery of net new tonnes will be the key for consensus pricing to sit around USD 85 per tonne. Failure for Brazil to deliver net new tonnes in 2016 will see the long-term price rise above the market consensus. This would be a positive for the lowergrade producers including Fortescue and Atlas.

In the short term however, the market will remain well supplied for the remainder of this year as Chinese steel consumption seasonally weakens in the third and fourth quarters. The cost curve has shifted down structurally. USD 100 per tonne will now be the new USD 120-130 per tonne.

Grade discounts are now the focus, rather than the headline benchmark price. The potential risk, particularly for low-grade iron ore producers, is how large these discounts can grow.

By James Eginton

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Disclaimer

This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. Reference to individual stocks in this material neither promise that the stocks will be incorporated into the Tyndall Australian equity portfolios nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

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Figure 3: Vale, Carajas iron ore pit (Source: Tyndall AM).

With the football World Cup recently held in Brazil, it is worth mentioning another large contributor to the Brazilian economy – iron ore.

Brazil remains the second largest seaborne supplier of iron ore to China (behind Australia) and is home to the world’s largest iron ore producer, Vale. Following a recent research trip, I believe Brazil remains crucial to the supply-demand balance in the seaborne iron ore market and will have significant ramifications for prices over the medium to long term.

Brazil is a large, high-quality iron ore supplier

Morgan Stanley estimates that Brazil will export 320 million tonnes (mt) of iron ore in 2014, of which Vale will export 265mt. What is often not mentioned when comparing Brazil to Australia, is the superior quality of Brazil’s iron ore. Average iron ore grades from Brazil are well above the benchmark 62% iron (Fe) content that is often quoted. Vale produces products with up to 66% iron content. This is in stark contrast to Australian iron producer, Fortescue Metals, which produces sub-60% iron content. The key saleable iron ore grade from Rio Tinto, who produces Australia’s highest quality iron ore, is 61% (for Pilbara Blend Fines).

A shift to a supply surplus has implications for pricing In recent years, a deficit in the supply of iron ore meant the grade differential between the various iron ore qualities did not result in any significant discounting. The adjustment to the lower iron content was made to the benchmark pricing plus an additional small penalty for the Chinese mills taking lower grade than they would otherwise like for their sinter feed (iron ore feed to the blast furnace). For the producers of low-grade products this was an excellent outcome but unsustainable.

Looking back over a longer time horizon, this has not been the case. When the market moves from a deficit of iron ore supply to a surplus, the steel mills are less willing to take a lower quality product. The lower-quality product produces more slag in steel making (and a less efficient blast furnace), requires steel mills to find higher-quality iron ore to blend and increases handling costs of iron ore as low-quality ore must be blended with a high-quality product. As a result, the small penalty that is separate from the grade adjustment has in fact been a significant penalty in the  past, as high as 30% in 2009 (as highlighted in figure 1).

Figure 1: A deficit in iron ore supply has kept the price discount low in recent years

We are now moving into a phase where the supply of iron ore has caught up with demand for iron ore. In 2014, new seaborne supply in the iron ore market will be approximately 110mt per annum. For the first time since 2008, Chinese domestic iron ore supply to steel mills will fall materially (by over 70mt). 2015 will see close to a further 100mt from both Brazil and Australia. The additional tonnes in 2014 are expected to be high-grade iron ore (60% to 66% Fe) from Rio Tinto (+50mt), Vale (+40mt) and other Brazilian producers(+20mt).Steel consumption will increase by approximately 3% in 2014from 2013 levels. Over the same period, seaborne iron ore supply will grow by 16%. The large increase in supply relative to the steel consumption increase will be balanced by the closure of high-cost production both domestically in China, but also from other non-traditional producers such as Africa and the Middle East. We believe this should provide a floor in the iron ore price of around USD 90 to 100 per tonne in 2014.

Quality not just quantity

The reason this will be a golden age for Brazilian iron ore is due to its quality. Vale produces high-quality iron ore, particularly in the northern system (region), with Vale’s Carajas project being among the best quality, large scale iron ore mines in the world. In addition, the new expansion project at Carajas, S11D,is expected to add 90mt per annum of supply by 2016. The cost of producing the S11D iron ore is a mere USD 11 per tonne (excluding freight costs), reflecting the size of the iron ore body, quality of the deposits and lower labour costs.

Compare this to Rio Tinto, which is in the mid-USD 30s per tonne (excluding freight costs) and the superior economics of the new Vale iron ore are easy to see. Adding another USD 20 per tonne for freight to China and Vale will deliver iron ore to Tianjin port for approximately USD 30 per tonne, while also receiving a premium to the 62% Fe index which will make the margin for the Vale product at almost USD 60 per tonne.

It is not just the Vale iron ore that has such great economics. A review of other iron ore producers in Brazil shows that the cost delivered to the port in Brazil for many producers is in the low USD 20s per tonne. The lack of infrastructure to load ships is preventing this production reaching the seaborne market.

Port owners are able to command over USD 20 per tonne to load a ship. Add another USD 20 per tonne for freight to China and these producers are delivering iron ore to Tianjin at USD 60 per tonne. This cost is still well below the likes of Fortescue Metals and well below some of the higher-cost mid-cap Australian producers – but above Rio Tinto and BHP.

What has held back Brazilian supply?

The question then becomes, if the economics are superior for these Brazilian projects, why have they failed to deliver net new tonnes to the seaborne market (as evidenced by figure 2)? The difficulty in delivering infrastructure solutions can never be underestimated. The junior Australian iron ore miners (those who produce less than 30 million tonnes of iron ore per year) who do not own rail or port facilities understand this challenge. This lack of infrastructure has hampered their ability to deliver tonnes to the market when prices were more favourable. Brazil suffers a similar fate. For the junior miners in Brazil, the biggest infrastructure problem they face is port access. Currently, two key companies control the major export ports for iron ore. They are Vale and Trafigura.

Figure 2: Brazil has lagged Australia in delivering supply

Vale has an incentive to keep iron ore prices supported and fill the market with their own tonnes of iron ore. They benefit from the port fees they are charging to load ships and also benefit from the slightly higher iron ore price. If they increase the port capacity, Vale will likely lower the loading fee of approximately USD 20 per tonne and will increase seaborne supply, helping to push the iron ore price lower.

Trafigura is a global trading house. By controlling supply, they can ultimately influence pricing which they rely on for their trading business. Therefore, there is not a great incentive for port expansion for non-Vale tonnes. It is this tonnage that is uncertain to come to the market by 2016 as forecast.

In addition to infrastructure challenges in Brazil, the other issue Vale has faced is environmental approvals. Carajas sits in the mountains of Northern Brazil (see figure 3). Deep in the jungle, the environmental challenges of developing mining operations has forced the government to consider the impact on the natural environment. Among the challenges are the potential destruction of caves and forest areas which affect flora and fauna. Until recently, this has been the biggest hurdle in the expansion of the S11D project.

The tide is turning for Brazil iron ore

It appears that the government is finally turning to a more favourable view on Vale expansion projects. In July 2013, the Brazilian government approved the construction of S11D, three years after the company originally expected to be granted approval. There remains one licensing hurdle to completion and the exporting of ore, and that can only be achieved once construction is complete. The recent approval shows the intent of the government to allow Vale to grow and suggests the years of frustration that have delayed production expansion (as evidenced in figure 4) may finally be over. With these tonnes, it will further reduce the need for low-quality iron ore, which suggests the low-grade iron ore produced by the Australian mid-tier miners (including Fortescue) could struggle to find a home.

Figure 4: Vale supply guidance has consistently disappointed

Increased focus on the low-grade iron ore discount

Vale has spoken of their desire to push the low-grade discount down further. They are opening a blending facility in Malaysia, with the purpose of blending their high-grade, low impurity

Carajas ore with their lower-quality, higher impurity southern system ore. The result is a product of around 64-65% iron content. The CFO of Vale recently confirmed to me during a meeting while on the research trip to Brazil, their goal is to address the company’s concern that they were not receiving a big enough premium for their high-quality iron ore (the flip side being that Fortescue was not receiving a big enough discount for their low-grade iron ore). Vale has not been happy with Chinese steel mills blending their product with lower-grade product – from Australia in particular.

It will be interesting to follow the grade discount rather than the headline price over the next six months. The big producers such as Rio Tinto, BHP Billiton and Vale have the ability to increase high-grade iron ore production and shift the mix to meet market demands and take advantage of premiums or avoid discounts. Fortescue on the other hand (and the junior iron ore miners) are more limited. It should be noted that the junior miners in a lot of cases have developed resources that BHP Billiton and Rio Tinto no longer wanted when the iron ore price was in the USD 30s per tonne. The junior minors have limited flexibility to improve grades without increasing production costs substantially.

The situation developing in Brazil will be making many Australian iron ore miners sit up and watch, and it won’t just be for the football. Brazil remains the key unknown to where prices and discounts in the iron ore market will sit. Delivery of net new tonnes will be the key for consensus pricing to sit around USD 85 per tonne. Failure for Brazil to deliver net new tonnes in 2016 will see the long-term price rise above the market consensus. This would be a positive for the lowergrade producers including Fortescue and Atlas.

In the short term however, the market will remain well supplied for the remainder of this year as Chinese steel consumption seasonally weakens in the third and fourth quarters. The cost curve has shifted down structurally. USD 100 per tonne will now be the new USD 120-130 per tonne.

Grade discounts are now the focus, rather than the headline benchmark price. The potential risk, particularly for low-grade iron ore producers, is how large these discounts can grow.

By James Eginton

———-

Disclaimer

This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. Reference to individual stocks in this material neither promise that the stocks will be incorporated into the Tyndall Australian equity portfolios nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

The post A golden age for Brazilian iron ore? appeared first on AdviserVoice.

However, the returns on fixed income have actually been superior to the returns on term deposits over the past 10 years. Given the current economic environment both globally and domestically, cash rates are likely to remain lower for longer, which should keep bond prices higher and term deposit rates lower. As a result, Australian investors may want to reassess their low exposure to fixed income. 

Q: Is Australia unusual in its preference for cash vs fixed income?

A: The simple answer is yes. Historically, Australian investors have preferred cash rather than fixed income as the default position for the defensive asset holding in their investment portfolios. Although US investors have held around the same amount of equities as an Australian investor, instead of cash they held more of their portfolios in fixed income.

Pension Fund Asset Allocation in Selected OECD Countries, 2012

 Source: OECD Global Pension Statistics

The “Other” category includes loans, land and buildings, unallocated insurance contracts, hedge funds, private equity funds, structured products, other mutual funds (i.e. not invested in cash, bills and bonds, shares or land and buildings) and other investments.

For Australia, Source: Australian Bureau of Statistics. The high value for the “Other” category is driven mainly by net equity of pension life office reserves (14% of total investment).
For Canada, the high value for the “Other” category is driven mainly by other investments of mutual funds (15% of total investment).
For Japan, Source: Bank of Japan. The high value for the “Other” category is driven mainly by accounts payable and receivable (22% of total investment) and outward investments in securities (21% of total investment).

For Germany, the high value for the “Other” category is driven mainly by loans (18% of total investment) and other investments of mutual funds (17% of total investment).

 Q: What are the reasons for this disparity?

A: It is partly due to a lack of familiarity with fixed income in the Australian market and partly because historically Australian cash rates were high, leaving very little premium between the cash rate and the yield on the 10-year bond. By contrast, US investors historically have been paid to hold 10-year bonds and so have been incentivised to hold long duration assets.

Q: What was the effect on Australian investors of holding cash rather than fixed income?

A: Given the high yields available on Australian term deposits, the decision to hold them rather than bonds may be seen as rational and appropriate in a high inflation environment. However, such  investors missed out on the major benefit of holding high quality bonds – the negative correlation they provide to equities. This particularly came to light in the GFC when equity prices collapsed and many Australian investors had no fixed income exposure to offset the negative returns from equities. In fact, as cash rates fell to help stabilise the economy, cash holdings performed poorly compared with fixed income.

Q: What’s the difference in long-term returns between fixed income and term deposits?

A: The returns on fixed income have surpassed term deposits over the longer term despite the fact the Australian yield curve has been so flat over the past 10 years.  Although investors in cash believed they were investing in an asset class which was offering higher returns, actual returns were higher for true fixed income funds since cash and term deposit holdings missed out on the capital returns enjoyed by bonds. When choosing where to allocate funds, it seems that investors are more concerned about ex ante returns than the returns they would have got from an asset class they don’t own.

Bonds outperform term deposits over the long term

Source: Mercer Insight; RBA (data reference: FRDIRBTD10KAR)

Dividends and distributions are reinvested. Returns are gross (pre fees, pre tax) and assume reinvestment of distributions.
*Term deposit return is the average rate on $10,000 term deposits across all terms at the five largest banks, including their advertised ‘specials’ and regular rates (using the monthly effective rate)

Q: Will we see domestic investors looking more closely at fixed income for their liquid or defensive asset class holdings?

In our view, they should but the problem is that investors are still scared off by the fact that bond markets have had a 20-year rally and rates must return to their normal levels from the current historically low yields.

Bond markets have had a 20-year rally in Australia and this has been due to the fact the neutral rate for cash has fallen as inflation has fallen. The Reserve Bank of Australia (RBA) has an inflation target of 2-3%. The success of the RBA in achieving its target has resulted in the financial market viewing it as credible. Since longer-term bonds use this as a realistic inflation level, it has lowered the risk premium around future inflation levels helping to lower bond yields and raise prices.

Q: Bond yields are historically low: is this likely to continue?

A: Central banks globally have intervened to lower bond rates. They could not cut cash rates below zero and so embarked on unconventional policies, such as quantitative easing (QE) to help repair their economies. QE has depressed real rates and term premiums globally. Many of these programmes have stopped or are being tapered. In 2013, US rates rose by 100 bps on the back of the Federal Reserve’s tapering of QE. However, the Fed still holds a vast quantity of fixed income securities on its balance sheet. This is not just holding up bond prices (therefore keeping yields low) but also bolstering all risky assets, including equities.  While QE persists, bond yields will remain depressed.

As we have stated previously, Tyndall views the new neutral rate for cash as being around 4.0%, which would imply a normal rate for the 10-year bond yield of around 5.0% (100 bps above its current level of 4.0%).  With the cash rate at 2.5%, even the current low bond yields are still providing a better return than cash.

Q: What will be the impact on Australia of lower rates for longer?

Australia’s household debt to disposable income is at record highs at around 148%[1]. With the decline in the terms of trade, low wages and low returns, income growth will remain low. As a result, monetary policy will have a stronger impact on the economy and won’t require large increases in interest rates to have the desired effect on the economy as we have seen in previous cycles. With cash rates low and likely to remain low and term deposit rates falling, Australian investors may start considering increasing their exposure to fixed income.

The risk of being so underinvested is a major one that is often ignored and leaves investors exposed not only to a potential fall in the cash rate but also the current low interest rate environment.  Apart from bonds’ defensive qualities and negative correlation to equities, the longer term threat of low inflation and the inability of central banks to adequately deal with it also warrants an allocation to bonds, in our opinion.

[1] Source: Reserve Bank of Australia, table E2, http://www.rba.gov.au/statistics/tables/index.html.

By Roger Bridges, Head of Fixed Income Strategy, Tyndall AM

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual.  The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

The Tyndall Australian Bond Fund (ARSN 098 736 255) is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL 229664, a related entity of Tyndall AM.  Potential investors should obtain their own independent advice and consider the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.

Mining: How deep is the hole?

Chart 1 shows that mining as a percentage of GDP is at record highs, although it has started to drop off. The rise in mining has resulted not only in mining capex rising as a percentage of GDP spending, but also that total capital spending has been boosted. We know that a sizeable decline in mining investment is approaching, with capex falling. However, the end of the investment phase of the mining boom is going to be partially offset by the increase in net exports as capital imports fall and exports grow, helping to support GDP growth as the production phase begins.

Nevertheless, the transition will entail jobs losses as fewer workers are required for the production phase. In addition, there will be an income shock for those transitioning away from mining since wages will be lower as non-mining jobs tend to pay less.

Exchange rate and interest rate sensitive sectors which have been hurt by the high Australian dollar and relatively high interest rates (such as housing, overseas education, and tourism) need to recover to help offset the drop in mining investment and they must grow to keep unemployment down. Low interest rates are currently helping housing and consumption but we also need a lower Australian dollar for tourism and education.

How does iron ore factor into the story?

The supply of iron ore has lagged the surge in demand for steelmaking in China, which has led to a quadrupling of its price over the past decade. While supply from India and Brazil has continued to lag, seaborne supply from Australia has increased due to production increases by BHP Billiton, Rio Tinto and, more recently, by Fortescue Metals.

Over the past five years, a lack of overseas iron ore supply to Chinese steel mills has meant that steel producers supplemented it with high cost, low quality domestic iron ore. This pushed up the iron ore price, which in turn gave strength to the AUD.

At the start of 2014, the market expected iron ore prices to fall, as has recently been seen, due to the removal of a large portion of this Chinese domestic supply. In addition, the iron ore market should transition from being in a deficit position to a mild surplus due to increased supply, largely from the lower cost producers in Australia, which will also help to subdue prices.

If iron ore prices drop, isn’t it bad news for the AUD?

Not necessarily. Although prices may fall slightly, the increase in volumes that Australia supplies to China should help to prop up the AUD, which in the past had been driven to some extent by the iron ore price (see chart 2). However, we can also note from the chart that the iron price started falling in September 2011 but this had little effect on the AUD.

Will iron ore exports help Australia’s current account position?

Australia has historically experienced current account deficits as the norm. Moving the budget from a deficit to a current account surplus will require, among other things, a shift to a trade surplus. There should be a significant rise in resource export volumes as the mining boom transitions from the investment to the production stage.

Despite the drop in iron ore prices, export values are increasing due to these greater volumes.  This is expected to continue since Australian iron ore is a low cost, high quality product and is replacing current production of high cost, low quality products in other major export markets. As a result, iron ore now represents nearly 30% of Australian total exports measured by value (see chart 3).

This added around 0.5% to December quarter 2013 GDP growth as the balance of trade went from a deficit to a surplus. The trade account has been largely in surplus from 2008-2012 due to the impact of higher terms of trade. Although the terms of trade remain high, they have fallen from the peak reached in 2012. However, the trade account has not returned to a deficit, like it did in 2009, because capital imports have fallen and volumes of iron ore exports have increased.

Will a current account surplus be positive for the AUD?

The trade account is likely to remain in surplus as the volume of iron ore exports accelerates. Additionally, this increase is currently offsetting the fall in the iron ore price so we should see the AUD more stable going forward. This impact from iron ore should be compounded as the liquid natural gas (LNG) projects are completed and proceed to the production phase, which should further underpin the currency.

What does this mean for the Australian bonds and the cash rate?

Australian government bonds are currently experiencing sustained low yields due in part to the current economic environment and offshore buying. 10-year bond yields are now sitting at around what we view as the new neutral rate of 4.00%, but 3-year yields remain much lower. In our view, we should expect lower rates for longer, which may keep a lid on yield rises. With the recent budget announcement of a reduction in bond issuance, there may also be a small positive effect on our bond market due to reduced supply.

In our view, the Reserve Bank of Australia (RBA)  is at the end of its easing cycle and our base case is that the RBA will keep rates on hold at 2.50% for some time to allow historically low rates to help the economy rebalance and that the next move in rates will be upwards.

However, the timing of rate hikes will not be as early as in previous easing cycles over the past two decades as the present shock to the economy, with the mining boom shifting from the investment to the production stage, requires low interest rates to help smooth the economy’s transition.

The drag on growth this year and next year from the budget is unlikely to be that great due to the government’s back loading of cuts, but it won’t help a fragile economy that is in the process of transitioning from the mining boom. Infrastructure spending will take a few years to come through and announced job cuts won’t help the unemployment rate.

If the budget measures negatively affect consumer sentiment for a prolonged period, then this could also be a drag on economic growth, as could any strength that it gives to the AUD.  All this is likely to keep the RBA on hold for at least this year and perhaps now for longer than previously expected.

Tyndall has launched Bonding with Income – an information kit which aims to help advisers educate their clients about investing in the asset class. Aimed at financial advisers, the guide explains how bonds work and how fund managers choose which bonds to buy, as well as outlining the risks and rewards of adding an active fixed income manager to an investor’s portfolio. Advisers can earn 3 CPD points towards their professional standards by taking the accompanying online quiz. Visit the Tyndall site to access the Bonding with Income guide and do the CPD quiz.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual.  The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

Background

Many empirical studies have shown that a value style approach to share investing has consistently outperformed growth investing – and with less risk. Other studies have shown that lower volatility portfolios, particularly lower beta portfolios, outperform higher beta portfolios.  Concentrated equity portfolios have also proven to outperform their more diversified counterparts.

If value, lower beta and concentrated portfolios have consistently outperformed in the past, then isn’t it only a matter of time before investors arbitrage this away? If this was true, then these ‘anomalies’ should have disappeared a very long time ago as they have been documented for many years. In fact, these so called ‘anomalies’ are a permanent feature of share markets.

The first two articles looked at the value investing and low beta portfolios anomaly. This article focuses on the third anomaly – the outperformance of concentrated portfolios.

Diversification or “diworsification”[1] : The case for concentrated portfolios

A third source of outperformance for equity portfolios is concentrated portfolios.  Studies have shown that concentrated portfolios are more likely to outperform their more diversified counterparts.

One such study, conducted in 2006 by Jeffrey A Busse, T Clifton Green and  Klass Baks at the Emory University concluded that “focused (ie concentrated) managers outperform their more broadly diversified counterparts by approximately 30 basis points per month, or roughly 4% annualised”.[2]

Another group of academics (Randolph B. Cohen, Christopher Polk and Bernhard Silli)[3] have found that institutional managers do have some identifiable skill in picking stocks. The researchers evaluated the performance of institutional investors ‘best ideas’, which they defined as being those stocks with the highest active positions.

Chart 1 sourced from Cohen, Polk and Silli’s Best Ideas paper, shows the alpha generated by managers’ best idea, second best idea, down to their tenth best idea. What is evident is that the manager’s largest active positions do in fact add significant value.

This is an interesting finding given the widespread belief, backed to some degree by academic research, that institutional active managers as a group do not add value, especially after fees. Given the research from Cohen, Polk and Silli indicates managers actually can identify stocks which will outperform, why then, as a group are they not capable of adding value to investors’ portfolios?

The question is seemingly answered by another interesting finding from the research. Diversification within individual portfolios increased materially over the past 30-odd years. Chart 2 shows the growth in the average number of companies held in US mutual funds doubled between 1984 and 2007.

Chart 2 suggests that while institutions are capable of finding good investments, they dilute the benefit through excessive diversification.

The obvious question that follows is why does this occur? Cohen, Polk and Silli offer a number of potential explanations:

1.     Regulatory/legal. Do legal standards such as the ‘prudent man’ lead to over-diversification in the name of regulatory risk aversion?

2.     Price impact, liquidity and asset gathering. Many institutional managers are paid as a percentage of funds under management. Consequently they have a financial incentive to maximise funds under management. With liquidity limitations and price impact increasing with the weight of money applied, institutions that exhaust the capacity of their alpha- generating ideas may be tempted to continue collecting funds under management and applying it to less attractive opportunities.

3.     Career risk. Underperforming managers face the risk of losing their jobs. Consequently, simply for self-preservation reasons, fund managers may choose not to deviate materially from the benchmark. It has been noted that it is only those managers that materially underperform their benchmarks that tend to be dismissed by clients. Mediocre managers tend to be retained.

Armed with this knowledge, what should advisers and institutional investors do?

There are a number of options that could be considered:

• Look for managers with performance fees. This will limit the incentive for asset gathering.
• Take a longer-term view of performance. This will empower your fund managers to take appropriate risks without the fear of being replaced should there be a period of short- term under performance.
• Accept that you need to do something different. For an outcome to be different to everyone else (ie the market), you need to do something different.
• Look for unconstrained portfolios or benchmark unaware funds. Managers of benchmark unaware funds will be less constrained by the need to deliver performance close to the benchmark over short time frames. As a consequence, these managers can focus on their best ideas without a need to dilute the potential returns through diversification.
• Consider concentrated managers. Concentrated portfolios eliminate or reduce a manager’s ability to ‘di-worsify’. A portfolio with limited names provides reduced opportunities for a fund manager to introduce portfolio fillers. Managers can be tempted to use portfolio fillers to reduce tracking error and thereby reduce relative performance risk. The problem with such action, as was pointed out above, is that by reducing relative performance risk, managers also reduce absolute performance potential and dilute their ability to add value through stock selection.

How can investors tap into these three sources of outperformance?

It is possible to tap into these the potential sources of outperformance, value, lower beta and concentrated portfolios, in the one fund.

The Tyndall Australian Share Concentrated strategy, launched in 2003, is a high conviction, concentrated Australian share portfolio comprising the best stock ideas identified through Tyndall’s proprietary research. The strategy invests in 15-25 stocks in the S&P/ASX 200 Index and is managed using Tyndall’s highly regarded and proven Intrinsic Value process.

The strategy’s performance objective is to provide long-term capital growth and income. To achieve this, the strategy seeks to invest in stocks that have a high total return but also a decent sustainable dividend yield.

The strategy has historically had a lower beta than the market (typically in a range of 0.75-0.90).

As illustrated in part 1 of this series, value investing has outperformed growth investing over the long term.  We are pleased to report that the Tyndall Australian Share Concentrated strategy has outperformed the Citigroup Value Index over the past 10 years as highlighted in chart 3.

A unit trust, which is managed using the same underlying strategy, was launched to the retail market in May 2010 and it ranked in the top 10 Australian share funds in the Mercer Survey in both 2012 and 2013.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Concentrated Fund (TASCF) ARSN 143 598 556 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (TAML). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. Reference to individual stocks in this material neither promise that the stocks will be incorporated into TASCF nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

Ukraine volatility forces Nikoo AM to re-evaluate equities position.

The volatile geopolitical situation in Eastern Ukraine and the prospect for prolonged negative news out of China continue to weigh on Nikko Asset Management’s stance on global equities, which the Tokyo-based asset manager cut to neutral from overweight last month. Nikko Asset Management is a related entity of Tyndall Investment Management Limited. In its latest research report, Evolving Markets, the firm’s analysts provide detailed analysis of these risk factors as well as an overview of the most (and least) attractive emerging markets.

The situation in Eastern Ukraine may be more perilous than many realize because vital production facilities for military equipment, including missile, aircraft and naval engines are located in the region and which Russia is not likely to permit coming under the control of a hostile government.

“While we did not previously believe that Russia would invade Eastern Ukraine, we did expect ethnic violence to occur there,” said John F. Vail, Chief Global Strategist and Chairman of the Global Investment Committee. “However, now we have to admit that some form of Russian presence, perhaps ‘peacekeepers’ requested by the separatists, is likely. Whether opponents of strong Russian control in Eastern Ukraine decide to fight these peacekeepers is a key question, but it clearly could become more unstable than the Crimean example.”

Meanwhile, in China, Nikko Asset Management continues to believe the country will be able to avoid a hard landing even though negative news is accelerating on several fronts. Property price declines are spreading—with secondary prices starting to fall in many second- and third-tier cities—while the government is pushing even harder to rein in the shadow banking system, which provides funding to many struggling sectors of the economy.

“Falling property prices put a damper on investor sentiment, and also lead to less activity in the crucial housing construction industry,” Vail said. “Rising defaults among the shadow banks will lead to a rise in banks’ non-performing loans, but in the long run the government is doing the right thing in instilling some discipline in lending activity.”

In the emerging markets, Nikko Asset Management’s top investment professionals covering equities, fixed income and forex have updated their views on the relative attractiveness of several countries, based on a ranking of average scores across six categories: 1) the direction of the one-year interest rate, 2) the direction of the forex rate, 3) equity earnings growth, 4) equity valuations (based upon several measures), 5) political risk and 6) vulnerability to credit or property market downturns.

The most attractive emerging markets are India, Korea and Mexico, while the most unattractive markets are Chile, Egypt, Russia, South Africa, Thailand and Turkey. In the middle, average-scoring countries include China, Indonesia, Malaysia, Peru, the Philippines and Vietnam. Brazil scores slightly below average.

Overall, Nikko Asset Management is cautious on emerging markets equities as a whole, even though certain countries offer excellent prospects; nevertheless, investors should be cautious about the political risks associated with this asset class.

Background

Many empirical studies have shown that a value style approach to share investing has consistently outperformed growth investing – and with less risk. Other studies have shown that lower volatility portfolios, particularly lower beta portfolios, outperform higher beta portfolios.  Concentrated equity portfolios have also proven to outperform their more diversified counterparts.

If value, lower beta and concentrated portfolios have consistently outperformed in the past, then isn’t it only a matter of time before investors arbitrage this away? If this was true, then these ‘anomalies’ should have disappeared a very long time ago as they have been documented for many years. In fact, these so called ‘anomalies’ are a permanent feature of share markets.

The first article looked at the value investing anomaly. This article focuses on lower beta portfolios.

Lower beta portfolios outperform higher beta portfolios

There have been numerous empirical studies showing that lower volatility portfolios, and in particular, lower beta portfolios, outperform higher beta portfolios.  This phenomenon is widespread and applies to most equity markets, including the US and Australia.

Clearly, this is contrary to the Efficient Market Hypothesis and the well-known investment axiom of “the higher the risk, the higher the return”.

Certainly, as shown above, as value portfolios tend to have a lower beta and have outperformed in the long run, value is one potential subset of lower beta portfolios.

A quote from Eugene F. Fama and Kenneth R. French (American economist and Nobel laureate in Economics, and Professor of Finance respectively, known for their work on portfolio theory and asset pricing, both theoretical and empirical) from one of their papers in the Journal of Economic Perspectives which was published in August 2004 provides a succinct summary of our view.

“…funds that concentrate on low beta stocks, small stocks, or value stocks will tend to produce positive abnormal returns… even when the fund managers have no special talent for picking winners.”[1]

MSCI produces minimum volatility returns based on the MSCI index constituents, which is a proxy for low beta portfolios.  It is constructed using the Barra risk model and is subject to holding constraints by stock and sector.

As table 1 shows, the MSCI Minimum Volatility Index has outperformed the MSCI broader market index by 0.38% pa – despite targeting lower beta (or lower risk) portfolios by construction.

For completeness, comparable numbers were produced for global equities using the MSCI World Index.  As can be seen in table 2, the numbers show an even more compelling story than Australia, with the MSCI Minimum Volatility Index outperforming the MSCI by 1.52% pa.

The reason why the numbers are more pronounced for the global market may be explained by the greater number of stocks to choose from while still constructing the portfolio within the portfolio constraints.

To test how meaningful these results are, t-statistics have also been calculated in table 3. The t-statistics are not as convincing as they were for value, but they are still on the right side of the ledger.  What they do imply is that a longer time frame is required for the outperformance to come through than the time frame required for value.

Why does low beta investing work?

There are various theories as to why lower beta (or lower risk) stocks tend to outperform higher beta stocks.  The theory that makes the most sense to us is the ‘lottery effect’ of high beta stocks.  This is where investors focus only on the upside or ‘blue sky’ scenarios and bid up the price of a stock on the hope that it could be a ‘ten bagger’ (ie worth 10 times its original amount) without fully incorporating the impact of the potential downside.  This also leads to some investors disregarding the steady, boring stocks as they chase the ‘sexy’ stocks that could make them rich – but in most cases never do… just like the lottery.  We have seen this occur many times in the past.

Another theory is that the lower beta stocks are on average inherently boring and conservative and have good stable cash flows.  As such, they tend to be higher dividend-paying stocks. These dividends are actually cash returns that help to underpin portfolio returns.

Table 4 provides a list of the top 10 lowest beta stocks and top 10 highest beta stocks in the ASX 50 Index as at January 2014.  The names in each list should not be a surprise – reflecting largely the nature of the industries the stocks are in.

One more theory that has emerged recently as to why low beta stocks outperform is the impact of ‘index aware’ investing, and portfolio manager bonuses rewarding more ‘risky’ behaviour in their stock selection – as they don’t get negative bonuses.  It is by virtue of managing portfolios against an index weight, portfolio managers may be compelled to hold higher beta stocks whether they like it or not, and as such, leads to inefficient pricing.  In conjunction with this, the ‘lottery effect’ discussed above comes into play, as some portfolio managers look to achieve big short-term outperformance by taking active positions in higher beta stocks, so as to receive big bonuses.

Chart 1, sourced from Nardin L Baker and Robert A Haugen (in their paper Low Risk Stocks Outperform within All Observable Markets of the World, 2012), depicts this notion graphically, albeit utilising volatility as the risk measure. The ideas are comparable. Given equity markets are considered to rise over time, a manager paid a bonus for outperformance may skew the portfolio to those stocks expected to rise more than the market – ie higher beta stocks.

Other potential explanations outlined by Baker and Haugen in their paper include lower volatility stocks are harder sell to a portfolio manager or investment committee. This is a function of the tendency for low beta and low volatility stocks to have a boring narrative relative to higher beta/higher volatility names and is suggested to have an impact on institution stock selection.

Baker and Haugen conducted research on the largest 1,000 stocks in the US between 2000 and 2009. They categorised these into ten deciles by market capitalisation, from the smallest (on the left in chart 2) to the largest (on the far right). The blue bar shows the stocks that institutions own more of, and the red bar shows the stocks that institutions own less of, within each capitalisation decile. Their research showed that institutions tended to own more of the higher volatility stocks – regardless of market capitalisation. The very smallest stocks were the only exception, where it was lineball.

The more volatile stocks also tend to have greater intensity of broking analyst coverage and greater news coverage.

However, while low beta investing does work in the long run, there are times when it can be in the wilderness for some time, as noted by the lower t-statistics.  These are typically when the market is in the latter stages of a massive bull run or when the market is driven by speculative fads which typically mean the boring, but reliable, low beta stocks can be overlooked by investors for some time.

Intuitively, why will value and low beta continue to outperform?

If value as well as lower beta has consistently outperformed in the past and has done so for less risk, then isn’t it only a matter of time before investors arbitrage this away?  If this was true, then these ‘anomalies’ should have disappeared a very long time ago, as they have been well known and documented for many years.  In fact, these so-called anomalies are really a permanent feature of the share markets.

The real answer for why value investing and lower beta investing has outperformed and why it should continue to do so, may be answered by delving into behavioural finance ie the psychological decision making of investors.

Time and time again, history has repeated itself with the various booms and busts of share markets, and speculative bubbles within the share market itself as investors chase the latest fads and ‘fashionable’ stocks.  In each case, the markets have corrected themselves.  There are numerous examples of varying degrees that have occurred in individual stocks, individual sectors, in whole countries and regions.  They have occurred in so called ‘growth’ stocks which become ‘high beta’ stocks as they rise quickly relative to the market in a short period of time.

We can even go back to the 18^th Century for such examples as the ‘South Sea Company bubble’ in London.  It would seem that investors never learn from history.

In the United States, in the early 1970s there were the ‘Nifty Fifty’ stocks that were the favoured large stocks that raced up to excessive prices, while many of the other stocks were at bargain prices.  In Australia, there was the Poseidon boom in 1970, the speculative bubble in casino stocks in 1996, and short periods of heightened speculation in certain types of low- quality commodity-related stocks since 2003 and up to late 2010.

We only need to recall the Telecommunications/Media/Technology (TMT) boom of 2000 and its subsequent bust for a very dramatic example of when so-called growth and/or high beta stocks moved to stratospheric price levels, while solid companies with real cash flows were sold down heavily as investors chased the latest hot stock.

In each and every case, a great opportunity was created for those investors who stayed with value and did not get caught up in the hype. These opportunities will present themselves again well into the future due to the psychology of investors as inevitably, history will repeat itself again and again.

The next and final instalment from this three-part series will explore the anomaly of the outperformance of concentrated portfolios over their more diversified counterparts.

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[1] Source: Journal of Economic Perspectives – Volume 18, Number 3 – Summer 2004

Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Concentrated Fund (TASCF) ARSN 143 598 556 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (TAML). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. Reference to individual stocks in this material neither promise that the stocks will be incorporated into TASCF nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

Nikko AM adjusts its global equities position.

An overweight stance on global equities that lasted for over two-and-a-half years has been cut to neutral by Nikko Asset Management’s Global Investment Committee (GIC), the company announced yesterday. Nikko Asset Management is a related entity of Tyndall Investment Management Limited. In confirming the provisional decision made in early March, the Tokyo-based asset manager cited the following concerns:

1) Heightened fear of geopolitical risk,

2) Accelerating deterioration of China’s economy and financial system,

3) Subpar US and Japanese economic growth, and

4) Little room to re-rate Western equity valuations and continued deterioration in earnings estimates.

“We believe equity valuations have peaked and that markets will trade nervously going forward. On top of that, unsettled geopolitics make us uncomfortable and the fallout from China’s reform efforts could cause some shocks,” said John F. Vail, Chief Global Strategist and GIC Chairman. “In a few markets we expect equities to do well, but against the tunnel of uncertainty looming out there—and given the slim difference between our bond and equity return forecasts—we feel a neutral view on global equities versus bonds is warranted.”

Vail expressed his views in the firm’s most recent Evolving Markets research report. Elsewhere in the report, analysts reported that 2013 fourth-quarter data on overall corporate profits in Japan (including unlisted companies) was very positive, with a record-setting quarter-on-quarter increase in the pretax recurring profit margin, while the four-quarter average hit a new high of 4.6%.

The report concludes that several other indicators confirm that Abenomics is working much better than the pessimists suggest.

Background

Many empirical studies have shown that a value style approach to share investing has consistently outperformed growth investing – and with less risk. Other studies have shown that lower volatility portfolios, particularly lower beta portfolios, outperform higher beta portfolios.  Concentrated equity portfolios have also proven to outperform their more diversified counterparts.

If value, lower beta and concentrated portfolios have consistently outperformed in the past, then isn’t it only a matter of time before investors arbitrage this away? If this was true, then these ‘anomalies’ should have disappeared a very long time ago as they have been documented for many years. In fact, these so called ‘anomalies’ are a permanent feature of share markets.

This article looks at the first anomaly – value investing. 

Value has outperformed growth in the long term

There have been many studies on various equity markets which show that value has consistently outperformed growth. Typically, these studies defined value stocks as those with low ‘Price to Book’ ratios or in some cases low ‘Price to Historical Earnings’ ratios. It is also likely that this ‘anomaly’ will continue to persist in the future.

Among these empirical studies include Basu (1977), De Bondt & Thaler (1985) (1987), Lakonishok & Vishny (1994), Fama & French (1992), and Arshanapalli, Coggin & Doukas (1998).

Of course, this fact would come as no surprise to the many famous value investors, such as Warren Buffett and John Templeton, who have enjoyed enduring success with their share investments.

Australian market style indices produced by S&P/Citigroup, show that during the period October 1989 to January 2014, value investing in Australia has outperformed growth investing, as has been shown for the global share market.  (NB. This is the longest period we can obtain for Australian market style indices.)

During this period, value produced a return of 10.87% pa, while growth produced a return of 8.87% pa.  This means that value outperformed growth by 2.00% pa. In dollar terms, if $100 was invested in the S&P/Citigroup Value Index during this time period, it would have accumulated to $1,221 by January 2014, whereas for growth, the amount would have been materially lower at $786. Returns are before fees and taxes. Past performance is not an indicator of future performance.

Background

Chart 2 shows that during any 3-year time period, on most occasions, value has outperformed growth quite handsomely in Australia, as has been the case for global shares.   The key exception was during the unprecedented commodities and resources boom that fuelled economic growth in Australia for almost 10 years from 2003. This was driven by the rapid industrialisation of the most populated country in the world, China and in turn saw growth stocks outperform value stocks.

A cynic may argue that the only reason why value outperformed growth is because value shares are riskier than growth shares. Many value investors would totally disagree with this statement, and would argue that value investing is actually less risky than growth. 

Most value investors would argue that they pay 60 cents for something that is worth $1, and as such there is good margin of safety in the investments they undertake.

One measure of risk is the volatility of returns as measured by the standard deviation of returns.  As table 1 shows, value has been less volatile than growth with a standard deviation of 13.51% versus 14.27% for growth.

Another measure of risk is beta, which is essentially a measure of market risk and strips out the impact of stock-specific risk which can be diversified away. As table 1 shows, value has had less market risk than growth with a beta of 0.968 versus 1.028 for growth.

This analysis thus shows that not only has value outperformed growth by a significant margin, but it has done so with less risk.

Comparable numbers for global equities using the MSCI World Value/Growth Index, which co-incidentally has a longer history (January 1975 to January 2014), are provided in table 2. It should come as no surprise that the numbers for global equities tell a very similar story. Value has outperformed growth by 2.08% pa over the period and with lower risk with a standard deviation of 14.81% (versus 15.75% for growth) and a beta of 0.966 (versus 1.031 for growth).

How significant are these findings?

One way to measure the significance of a result, is to calculate a t-statistic.  In this case, we need to test how confident we can be that value will continue to outperform growth in the future. To do this, we need the historical outperformance of value over growth, the standard deviation of this outperformance, and the number of observations. Naturally, the greater the sample size, the more significant will be the result. The formula to calculate the t-statistic is provided below:

T-statistic = (outperformance/standard deviation of outperformance) x square-root (no. of observations)

As a general rule, a t-statistic of at least +1.0 is considered to be meaningful and +2.0 is considered be highly significant.  At +2.0, it implies at least a 98% probability that this ‘anomaly’ will persist in the future.

For Australia, the China-driven commodities boom has had a marked impact on the results, but despite this, we have a moderately meaningful result.  With a t-statistic of +1.4 (as shown in table 3), this implies a 92% probability that these performance and risk results will persist.

Can this anomaly continue? Overall we can be confident, at least from a statistical perspective that value will continue to outperform growth in both of these share markets.

Part 2 of this three-part series will focus on the second anomaly: lower beta portfolios outperform higher beta portfolios. It was also delve more into our reasons why we believe both of these anomalies will persist in the future.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Concentrated Fund (TASCF) ARSN 143 598 556 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (TAML). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. Reference to individual stocks in this material neither promise that the stocks will be incorporated into TASCF nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

Mr Potter joined Tyndall in 2002 and has 20 years’ industry experience (see biographies below). He has been co-managing Tyndall’s flagship Australian equity strategy with Mr Van Munster for the past seven years and in that time has delivered strong and consistent outperformance to clients. Mr Potter will maintain his portfolio management responsibilities in his role as head of the Australian equities team. Mr Van Munster has headed the Tyndall Australian equities business since 2000, and has worked with Mr Potter for 12 years.

Mike Davis, Tyndall AM’s managing director, said that this is a natural progression of the Australian equities business with succession planning being a strong focus for the team for many years. The Tyndall Australian equity dual portfolio management structure has been in place since 2007. This has been very successful for Tyndall, both in delivering strong performance outcomes for clients and retaining a stable, experienced and motivated team.

“Bob and Brad have made a major contribution to Tyndall’s success and are two of Australia’s foremost equities managers. We are naturally sad to see Bob leave the business and the industry, and understand this is his personal lifestyle choice.

“We have both an extremely capable and talented successor in Brad, and a very strong team that has worked together for an average of 12 years at Tyndall. We have a well-established investment process and philosophy that has proven itself over time and is endorsed by the entire team.”

Mr Van Munster’s co-management responsibilities for the Tyndall flagship Australian equity strategy will be taken over by portfolio manager Jason Kim, with effect from 1 May 2014. Mr Kim is one of the most experienced and talented portfolio managers in the team, responsible for managing the strong-performing Australian concentrated share strategy.

“Warwick Cumming will continue in his role as deputy head, providing high level support to Brad including team management and overall responsibility for research, allowing Brad to focus solely on generating strong performance for our clients,” Mr Davis said.

Yu-Ming Wang, Nikko AM CIO commented: “We are pleased to seamlessly transition our highly-rated and proven investment process for Australian equities from the skilled hands of Bob to Brad, Jason and Warwick. With an average of 18 years’ industry experience, the team under Bob’s leadership has been a top performer for us and we expect that to continue. We also wish Bob all the best in his retirement.”