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As expected volatility is back with a dose of reality

Peter Warnes  |  09 Feb 2018Text size  Decrease  Increase  |  
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Following on from Tuesday's early edition of the Overview--From FOMO to FONGO--it was interesting there was not a tweet from the President about the rout on US markets on Friday and Monday.

Belatedly: "In the old days, when good news was reported, the stock market would go up. Today, when good news is reported, the stock market goes down. Big mistake."

The two-year budget deal stitched up in Washington on Wednesday, US time, will significantly increase fiscal spending. It will need to be funded by borrowings upwards of US$2 trillion. Bond yields reacted immediately, equity market gains vaporised.

It appears the President may not understand that while higher bond yields may signal higher economic growth, it doesn't necessarily mean stock markets move higher.

Meaningful expectations are already factored into valuations, but higher bond yields will impact discount factors applied to cash flow, which can reduce valuations.

Acknowledge the past, but don't invest in it. A company's record is useful and can provide some insight into the future, but there is no certainty the past, good or bad, will be replicated.

The equities market reflects the distilled expectations of investors. Expectations, by definition, are crystal ball gazing. The slavishly followed volatility index (VIX) measures the expectation of volatility over the next 30 days. Expectations have been shredded over the past week and global stock market indices have reacted accordingly.

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All share valuations are based on expectations. Expectations for earnings involve numerous assumptions about the future including the outlook for bond yields (the risk-free rate), which determine the discount factor applied to future cash flows, to arrive at a discounted cash flow (DCF) valuation.

Bond yields are also used to value the assets of REITs, infrastructure, and utilities (the bond proxies) where capitalisation rates are tied to the risk-free rate.

Markets change direction when expectations change. The current shake-out reflects a change in expectations of inflation and bond yields. The knock-on effects on equity valuations starkly reflected in falling share prices.

Quite resolute expectations, backed up by the Dot Plot (the thoughts of each individual member of the Federal Open Market Committee), that the Fed will raise rates three times in 2018, now appear on increasingly shaky ground.

The more increases beyond expectations, the greater the risk equity values will come under increasing pressure.

Suggestions the market sell-off will become a buying opportunity state the bleeding obvious. But one can't buy unless funds are available to take advantage of the opportunities a falling market presents.

I have been urging subscribers to be squirrel-like over the past six months and I hope many have heeded the advice and sit patiently waiting to ambush the sellers.

Patience and a strategy required

The early bird catches the worm. My advice is not to be too early in buying into the current correction. Let it play out for a while. Rarely are corrections of two days duration. It is likely there will be more challenges ahead.

But it is also important to continue to focus on the long term and allow compounding to work for you. Those who have built cash reserves are in the best position to take advantage of undervalued situations as they present themselves.

Morningstar's monthly Global Best Ideas is a useful companion. The list presents our most undervalued companies across our global coverage of almost 1,500 companies. Have your wish list close by and be disciplined.

I would advise against putting all your cash reserves into the market at once. Dollar cost averaging is a strategy that works. Perhaps work in 20 per cent parcels over, say, six to nine months. Buy the saucer.

Make sure you have identified the strong companies, the ones you want to own for the long term. Remember, interest rates are going to normalise. They are going to rise from current historical lows.

Beware of companies with high debt levels unless cash flows are sustainable. Be careful of recommendations based on EBITDA and do not get sucked into what appears to be a low EBITDA multiple.

Given the level of debt, I would also be cautious of EBIT and EBIT multiples. There are many companies ("zombies") whose EBIT does not cover interest expense--that is, an interest cover of less than one. Beware in a rising interest rate environment as these could implode.

Focus on operating and free cash flow as this is from where dividends emanate. Look for a high rate of cash conversion from EBITDA to profit.

Finally, please, please do not have any margin debt!

Many of today's financial advisers have not seen interest rates rise. Interest rates will rise and investors and advisers will have to adjust to an entirely different environment than that of the past decade.

Time to drain our swamp--Lake Burley Griffin!

Following the introduction of lower corporate tax rates in the US, the Prime Minister and Treasurer have renewed their efforts to have Australia's corporate tax rate reduced from 30 per cent to 25 per cent.

A lower corporate tax rate may help Australian companies be more competitive, although Bill Shorten's latest call for the world's highest minimum wage may take off some of the shine. But in isolation a one-off cut in the tax rate may not be the answer.

One of the greatest impediments to our competitiveness is the proliferation of red tape. The requirement to meet an increasing number of regulations, forms to be completed and lodged, accompanied by an obligatory cheque, continues to stifle Australian business.

Widespread tax reform, not only in the corporate sector, accompanied by a complete overhaul, root and branch, of the bureaucracy is long overdue and should be the number one priority of government.

I can recall studying Income Law & Practice at university in the mid-1960s. Then the Australian Tax Act was just over 200 pages. Today it is over 6,000.

If government does not address the situation then perhaps it is time for a new Australian flag.

The Canadian and Japanese flags are easily recognisable. The red rising sun on a white background and a red maple leaf also on a white background. Perhaps it is time we changed colours to just red and white.

As a salute to our bureaucrats federal, state, and local--white to represent surrender and red, the colour of the tape they have bound us with. Imagine a flag with a roll of red tape in the centre of a white background, signifying the damage done to Australian business and our way of life.

Despite Australia's record of uninterrupted growth for almost 28 years, one wonders what could have been without the massive increase in regulation. Bureaucrats have severely maimed the productivity of business and the efficiency of capital.

They, along with every politician, should all be made to stand to attention every morning--rain, hail, or shine--and sing the three verses of Advance Australia Fair as the new flag is hoisted. They should reflect long and hard on the words "wealth for toil".

Trade deficits wipe out contribution of net exports to 4Q GDP growth

The December trade deficit surprised. Expectations for a $200 million surplus were in tatters with a deficit of $1.358 billion. This follows on from the combined $930 million deficit for October and November against consensus expectations of a near $2 billion surplus. The 4Q17 deficit of $2.3 billion means net exports will be a drag on GDP growth.

Consensus estimates went missing in the December quarter with a 0-for-three batting average. Estimates for a combined surplus of $2.2 billion had the arithmetic sign wrong with a deficit of $2.3 billion--a $4.5 billion miss! Consensus is not always a safe place to hide. 

A week for impairments

Wesfarmers (ASX: WES)--Homebase far from a home run. A billion goes west comprising a goodwill impairment of £444 million (A$777 million) recognised on the acquisition of Homebase and £10 million (A$18 million) against the remaining book value of the Homebase brand name, coupled with stock and deferred tax assets write-downs and store closure provisions totalling £130 million (A$228 million), taking the total non-cash hit to £584 million (A$1.023 billion).

In addition, there is an underlying 1H18 EBIT loss of £97 million (A$165 million). Instead of hitting a home run, it looks more like a bunt to short stop and run out at first!

In addition, troublesome Target chalked up another non-cash impairment to its already chequered record. This time $306 million before tax, with $238 million against the carrying value of the brand name, remaining goodwill of $47 million, and property and equipment of $21 million.

Marvellous how it's cash on the way out and non-cash when it doesn't go according to plan. This is not the ideal way to increase the return on equity!

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Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

 


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is Morningstar's head of equities research.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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