East to West: Trade tariffs spark rally

Commodities rallied and Asian stocks found support after a three-month sell-off.

DJ-UBS Commodity Index

From Reuters (September 19):

Copper jumped to its highest in three weeks on Wednesday, boosted by a weaker dollar after a new round of U.S.-China trade tariffs were not as high as previously expected.

China will levy tariffs on about $60 billion worth of U.S. goods in retaliation for U.S. tariffs on $200 billion worth of Chinese goods. Washington’s new duties, however, were set at 10 percent for now, rising to 25 percent by the end of the year, rather than starting immediately at 25 percent…….

“In some ways the bad news had been priced into the markets and, if anything, the news on trade had been slightly less severe than we had thought it would be,” said Capital Economic analyst Caroline Bain.

“It’s still too early to talk about this as sustainable … it just seems to be a bit of a relief rally after all of the bad news.”

The Shanghai Composite Index rallied off primary support at 2650, a slight bullish divergence on the Trend Index signaling short-term buying pressure. Penetration of the descending trendline would suggest that a bottom is forming.

Shanghai Composite Index

Japan’s Nikkei 225 is testing its January high at 24,000.

Nikkei 225 Index

India’s Nifty is testing support at 11,000. Long tails indicate buying pressure. Respect of support would signal another advance.

Nifty Index

Europe

Dow Jones Euro Stoxx 50 rallied off primary support at 3300 but is yet to break the down-trend.

DJ Euro Stoxx 600 Index

The Footsie also rallied, finding support at 7250, but a declining Trend Index warns of continued selling pressure.

FTSE 100 Index

North America

The S&P 500 rallied off the new support level at 2875 and is likely to test its long-term target of 3000.

S&P 500

The Nasdaq 100, however, continues to test support at 7700. Breach would warn of a correction to test 7000.

Nasdaq 100

Canada’s TSX 60 found support at 950 but declining peaks on the Trend Index continue to warn of selling pressure.

TSX 60 Index

Markets are dominated by one concern, a US-China trade war, and volatility is likely to remain high until a resolution is found.

Aussie gold stocks rally

Gold continues to find resistance at $1210/ounce. Trend Index peaks below zero warn of selling pressure. Respect of resistance would indicate another decline and a long-term target of the 2015 low at $1050/ounce.

Spot Gold in USD

Currencies

The PBOC is supporting the Yuan at 14.5 US cents.

CNY/USD

Support for the Yuan is driving down the Dollar. Dollar Index breach of support at 95 warns of a correction to test 91. Bearish divergence on the Trend Index warns of selling pressure. A falling Dollar is likely to boost demand for gold.

Dollar Index

The Australian Dollar benefited from the weaker greenback, rallying to test resistance at 73/73.5 US cents. Trend Index peaks below zero continue to warn of long-term selling pressure. Respect of resistance is likely and would signal a test of the 2015/2016 low at 70 US cents.

Australian Dollar/USD

Gold Stocks

Australian gold stocks rallied despite the strengthening Aussie Dollar. The All Ordinaries Gold Index (XGD) is likely to encounter stiff resistance between 4900 and 5100.  A Trend Index peak below zero would warn of further selling pressure and continuation of the down-trend.

All Ordinaries Gold Index

ASX 200: Banks lack support but miners receive a boost

The ASX 200 correction continues to test medium-term support at 6150. Small candles on the weekly chart indicate a lack of enthusiasm from buyers and support is unlikely to hold. Breach would signal a test of the rising long-term trendline at 6000.

ASX 200

The ASX 300 Banks index continues to test support at 7700. Declining Trend Index warns of selling pressure. Breach of support is likely and would signal a test of primary support at 7300.

ASX 300 Banks Index

The ASX 300 Metals & Mining, however, received a boost from stronger commodity prices and is testing resistance at 3750. A Trend Index peak near zero is less likely but would warn of selling pressure and a primary down-trend.

ASX 300 Metals & Mining

I remain cautious on Australian stocks, holding over 30% cash in the Australian Growth portfolio.

How will a bond bear market affect stocks?

10-Year Treasury yields broke out of their triangular consolidation at 3.00%, while the Trend Index recovered above zero signaling a fresh advance.

10-year Treasury Yield

Importance of resistance at 3.00% is best illustrated on a long-term monthly chart. Yields declined for more than three decades (since 1981) in a bond bull market but the rise above 3.00% completes a double-bottom reversal, warning of rising yields and a bond bear market. Target for the advance is 4.50%.

10-year Treasury Yield

The yield differential between 10-year and 3-month Treasuries has declined since 2010, prompting discussion as to whether a flat yield curve will cause a recession.  Interesting that the yield differential recovered almost 20 basis points in September, with long-term yields rising faster than short-term. Penetration of the descending trendline would suggest that an imminent negative yield curve is unlikely.

10-year Treasury Yield

How would a bond bear market affect stocks?

Capital losses from rising yields on long-maturity bonds would increase demand for shorter maturities, driving down short-term yields and causing a steeper yield curve. A bullish sign for stocks.

Inflation is low and the rise in long-term yields is likely to be gradual. Another bullish sign.

The last bond bear market lasted from the early 1950s to a peak in September 1981. Higher interest rates were driven by rising inflation ( indicated below by percentage change in the GDP implicit price deflator). The 1975 spike in inflation was caused by the OPEC oil embargo in retaliation for US support of Israel during the 1973 Yom Kippur war.

1950 to 1981: 10-Year Treasury Yields and GDP Implicit Price Deflator

Stock prices continued to climb during the bond bear market, apart from a 1973 – 1974 setback, but the Price-Earnings ratio fell sharply in ’73-’74 and only recovered 10 years later, in the mid-1980s.

1950 to 1981: S&P 500 and PE Ratio

Alarmists may jump to the conclusion that a bond bear market would lead to a similar massive fall in earnings multiples but there were other factors in play in 1975 to 1985.

First, crude prices spiked after the OPEC oil embargo and only retreated in the mid-1980s.

1960 to 1985: West Texas Intermediate Crude prices

The rise of Japan also threatened US dominance in global markets.

1960 to 1985: Nikkei 225 Index

We should rather examine the period prior to 1973 as indicative of a typical bond bear market. The S&P 500 Price-Earnings ratio was largely unaffected by rising yields. Real interest rates actually decreased during the period, with the gap between 10-year yields and the inflation rate only widening near the 1981 peak.

At present, real interest rates are near record lows.

1981 to 2018: 10-Year Treasury Yields and GDP Implicit Price Deflator

We can expect real interest rates to rise over time but that is unlikely to have a significant impact on earnings multiples — unless there is a strong surge in long-term yields ahead of inflation.

 

East to West: Asian stocks find support

Asian stocks are finding support after a sell-off over the last three months.

The Shanghai Composite Index is showing a slight bullish divergence on the Trend Index. This is secondary in size and suggests a bear market rally.

Shanghai Composite Index

South Korea’s Seoul Composite Index displays a stronger bullish divergence. Breakout above 2350 and the descending trendline is still unlikely but would indicate that a bottom is forming.

Seoul Composite Index

Japan’s Nikkei 225 broke through resistance at 23,000, signaling an advance to the January high at 24,000.

Nikkei 225 Index

India shows strong buying pressure, with long tails on the Nifty suggesting another strong advance.

Nifty Index

Europe

Dow Jones Euro Stoxx 600 is trending lower. Support at 374 is secondary but the Trend Index near zero indicates hesitancy.

DJ Euro Stoxx 600 Index

The Footsie found medium-term support at 7250 but a declining Trend Index warns of another test of primary support at 6900/7000.

FTSE 100 Index

North America

The S&P 500 retracement respected support at 2875, suggesting an advance to the long-term target of 3000.

S&P 500

Canada’s TSX 60 on the other hand is undergoing a correction, perhaps exacerbated by concerns over NAFTA. Expect support at 935/940.

TSX 60 Index

Nothing much has changed. While Japan and India are bullish, China and South Korea remain in a bear market. Europe looks hesitant, while the S&amp:P 500 continues in a strong bull market.

The generally accepted view is that markets are always right — that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.

~ George Soros

ASX 200: Correction to test 6000

The ASX 300 Banks index continues to test support at 7700. Declining Trend Index warns of medium-term selling pressure. Breach of support is likely and would signal a test of primary support at 7300.

ASX 300 Banks Index

The ASX 300 Metals & Mining index is also headed for a test of primary support, at 3400. A Trend Index peak at/below zero would warn of rising selling pressure and a primary down-trend.

ASX 300 Metals & Mining

Commodities are already in a primary down-trend but Australian stocks are partially cushioned by a weakening Aussie Dollar.

DJ-UBS Commodity Index

The ASX 200 found medium-term support at 6150 but this unlikely to hold. Bearish Divergence on the Trend Index warns of medium-term selling pressure. Expect a correction to test the rising long-term trendline at 6000.

ASX 200

I remain cautious on Australian stocks, holding over 30% cash in the Australian Growth portfolio.

Silver warns of further Gold weakness

Precious metals tend to trend or consolidate together, driven by similar investor motives. Spot silver is testing primary support at $14 per ounce, while a Trend Index peak at zero warns of selling pressure. Breach of support would signal a primary down-trend.

Spot Gold in USD

Gold is still testing support at $1200/ounce but Trend Index peaks below zero warn of selling pressure. Respect of the descending trendline indicates another decline with a long-term target of the 2015 low at $1050/ounce, similar to silver.

Spot Gold in USD

Currencies

The Yuan continues to test support at 14.5 US cents.

CNY/USD

The Dollar Index continues to test support at 95, despite the weak Yuan. Bearish divergence on the Trend Index warns of selling pressure but long tails indicate support. Breach of support at 95 is uncertain but would signal a correction to test 91 — boosting demand for gold.

Dollar Index

The Australian Dollar continues a strong down-trend, with Trend Index peaks below zero warning of selling pressure. Expect a test of the 2015/2016 low at 70 US cents.

Australian Dollar/USD

Gold Stocks

The falling Aussie Dollar has partially cushioned local gold stocks from weaker gold prices but gold is more volatile than the Dollar. The All Ordinaries Gold Index (XGD) is expected to break support at 4550, offering a long-term target of 4000/4100.

All Ordinaries Gold Index

BWP Trust (BWP)

Stock: BWP Trust
Symbol: BWP
Exchange: ASX
Financial Year-end: 30 June
Latest price: $3.39
Market cap: $2.17 billion AUD
Date: 13 September 2018

Sector: Real Estate
Industry: Retail REIT
Investment Theme: Dividends & Growth

Company Profile

BWP Trust is a real estate investment trust (REIT) established in 1998 that invests in and manages commercial properties throughout Australia.

Wesfarmers Limited owns approximately 24.75% of the issued units in the Trust. The responsible entity for managing the Trust, BWP Management Limited, is a wholly-owned subsidiary of Wesfarmers.

BWP owns a portfolio of 79 stores in Australia. The majority of the properties are large format retail properties leased to Bunnings Group Limited, a subsidiary of Wesfarmers. Eight of the properties have adjacent retail showrooms, leased to other retailers and there is one stand-alone showroom property.

Markets

Over 92% of rental income is from Bunnings (Wesfarmers).

98.8% of the portfolio was leased, with two properties unoccupied, at 30 June 2018.

Of the 79 properties, 13 are expected to be vacated by Bunnings (in the process of relocating to a nearby site, including some ex-Masters sites), including the two currently vacant. Five of the 13 properties are being sold and 8 are being re-positioned.

Financial performance

Revenue Growth

Annual revenue continued to rise, with 2.5% like-for-like rental growth in FY18 while total rent received grew by 0.35%.

Revenue and EPS

Long leases provide stability and growth.  Weighted average lease expiry (WALE) is 4.5 years. Initial Bunnings leases are typically 10 to 15 years with further options of 5 or 6 years.

Approximately 59% of rental income are subject to annual CPI adjustment and 41% to fixed annual adjustments,  typically reviewed to market every 5 years.

Rents are generally not linked to tenants’ turnover, but retailing conditions can impact on market rents. FY19 may bring some rent free periods and capital expenditure as 8 properties are re-positioned following Bunnings exit.

Earnings per share

Earnings include net unrealized gains in fair value of investment properties. Net increase in fair value of $67.4 million for FY18 is significantly lower than $111.3 million in FY17, accounting for the substantial drop in EPS.

Earnings per Share and Dividends

Excluding unrealized gains, EPS shows an increase of 0.65% in FY18.

Distributions, excluding capital, were 17.62 cents per share for FY18, an increase of 0.65%.

Historical growth (CAGR) in distributions from 1999 to 2018 is 3.5% p.a.

Cash Flow

Cash flow from operating activities and free cash flow both increased by 0.83% in FY18.

Net Income & Free Cash Flow % of Revenue

Capital structure

Net debt to equity of 25% is manageable.

Net Cash/(Debt) % of Equity

Weaknesses

BWP’s earnings are strongly linked to the ongoing success of Wesfarmers’ Bunnings business and their underlying markets: home improvement and outdoor living. While this business has a strong track record, declining housing prices are expected to weigh on performance.

Valuation

Net tangible assets (NTA) at FY18 were $2.85 per share. Decline in the weighted average capitalization rate to 6.48% in FY18 (FY17: 6.59%) accounted for most of the 4.0% increase in NTA.

We project current distributions of 17.62 cents (excluding capital distributions) will grow at a long-term rate of 2.5% per year, giving an expected annual return of 7.7% using Gordon’s Growth Model, or 8.1% including tax benefits.

Technical Analysis

Momentum (50-week) has risen to a modest 12%, while Trend Index (50-week) only recently crossed above zero. BWP has appreciated at an average of 6.0% CAGR since 1998.

Long-term

The shorter term Trend Index (21-day) formed a bullish trough near zero in late August/early September. Another trough at or above zero should provide a good entry point.

Short-term

Conclusion

We consider BWP to be over-priced at present: $2.95 would offer a long-term projected investment return of 8.5%, or 8.95% including tax advantages. Hold and accumulate if price dips below $3.00 per unit.

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above company.

Wesfarmers Ltd (WES)

Stock: Wesfarmers Ltd
Symbol: WES
Exchange: ASX
Financial Year-end: 30 June
Latest price: $51.34
Market cap: $58.1 billion AUD
Date: 11 September 2018

Sector: Consumer Staples
Industry: Food & Staples Retailing
Investment Theme: Dividends & Growth

Company Profile

From its origin in 1914 as a Western Australian farmers’ cooperative, Wesfarmers has grown into Australia’s largest listed conglomerate. Headquartered in Perth WA, Wesfarmers’ businesses span the retail and industrial landscape.

Retail delivers the bulk of group earnings: 88% of FY18 EBIT after allowing for sale of Resources. Operations include 809 Coles supermarkets; 711 convenience stores; 228 Kmart discount department stores and 256 Kmart Tyre & Auto centres; 187 large- and 116 small-format Target apparel and homewares stores; 899 Liquorland, 1st Choice and Vintage Cellars liquor outlets; 88 hotels; 165 Officeworks office supplies stores; and 259 Bunnings home improvement warehouses, 78 smaller format stores and 32 Trade outlets across ANZ.

The Industrials division includes chemicals and fertilizers, gas processing and distribution, industrial and safety products and coal-mining (sold in August 2018).

Markets & Competitors

Woolworths is Wesfarmers’ largest retail competitor, operating more than 1000 supermarkets, 183 Big W discount stores, and more than 1500 liquor outlets. Competition from Woolworths and Aldi (460 stores) has exerted pressure on Coles’ margins: EBIT fell to 3.8% of Revenue in FY18, compared to 4.1% in FY17.

Bunnings is the jewel in Wesfarmers’ crown, with the largest market share (30%) in the Australian hardware/home improvement/DIY sector4. Competing retailers include Home Timber & Hardware and Mitre 10 chains, as well as a large number of independents. Woolworths, through their Masters joint venture with US home improvement giant Lowes, tried to challenge Bunnings’ market dominance but failed dismally, ending in Masters closure and a $3.25 billion write-down.

Kmart and Target were merged under a single head of Department Stores (Ian Bailey to replace Guy Russo in November 2018). Some Target stores were rebranded as Kmart while others were closed due to their poor performance which resulted in FY16 $1.27 billion and FY18 $0.3 billion impairment charges before tax1.

Officeworks dominates the office supplies and stationery market but faces competition from Amazon with the launch of its online business supplies website.

Wesfarmers also hold a 25% stake in BWP Trust, a listed REIT which owns 79 Bunnings warehouse properties, 2 of which are now vacant, with Bunnings relocating some stores to former Masters premises.

Segments

Contribution to group EBIT by segment:

FY18 EBIT by Segment

Acquisitions and disposals will significantly alter composition of the group in FY19.

Acquisitions and Disposals

On 16 March 2018, Wesfarmers announced their intention to spin-off Coles as a separate ASX-listed company with an independent board, to be completed in FY19. Wesfarmers would retain a minority ownership interest (up to 20%) and a substantial ownership stake in Flybuys (supporting Wesfarmers’ & Coles’ data and digital initiatives)2.

Apart from the Coles spin-off, in recent months Wesfarmers shed a number of smaller subsidiaries:

  • Sale of 13.2 per cent indirect interest in Quadrant Energy Holdings to Santos Limited, expected to net a profit of $98 million before tax (August 2018);
  • Sale of Kmart Tyre and Auto Service business to Continental AG for $350 million, expected to net a profit of about $270 million before tax (August 2018);
  • Sale of 40% stake in Bengalla thermal coal mine to co-owner New Hope for $860 million (August 2018); and
  • Sale of Curragh coal mine in Queensland to Coronado Coal Group for $700 million, expected to net a profit of $110 million after tax (March 2018).

Wesfarmers earlier (May 2017) abandoned plans for an initial public offering of Officeworks after fund managers rejected the conglomerate’s $1.5 billion asking price because of weak Australian consumer discretionary spending and the prospect of increased competition with the arrival of Amazon in Australia.

Wesfarmers bought UK hardware chain Homebase for £340 million in February 2016, with the intention of rebranding the 265 stores in the UK and 15 in Ireland as part of the Bunnings group. After mounting losses, Wesfarmers threw in the towel, selling the entire UK and Ireland operation to turnaround specialist Hilco for a nominal £13, with an FY18 after-tax impairment charge of $1.4 billion1.

Michael Chaney in an interview with The Age explained:

Chaney was the chairman that signed off and despite everything contends he had never seen a more thorough investment analysis than had been undertaken on Bunnings UK. They had a base case set of projections and a downside case and it all looked very positive at the time according to Chaney. But a couple of fundamental mistakes were made subsequently after acquisition of Homebase home improvement network of stores including the removal of 150 senior managers.

“One was moving out the senior management and replacing it with our Australian experts and the second was getting rid of a lot of the products and the franchises because they didn’t suit the Bunnings model,” says Chaney. By way of example the Australian interlopers jettisoned Laura Ashley from the home decorator product line up – and British women voted with their purses.

It was the success of the Australian model and its management that blinded the higher ups inside Wesfarmers to the fact that these guys didn’t know better what the UK customers wanted. Wesfarmers got caught in the hubris trap.

Financial performance

Revenue Growth

Revenue growth stalled in FY18.

Revenue and EPS

Coles revenues grew by 0.4% to $39.4 billion in FY18 but EBIT margins declined to 3.8% (FY17: 4.1%). Food & Liquor (incl. hotels) comparable sales grew 1.1%, while headline sales grew 2.1% to $33.6 billion. Convenience stores fell 6.1% to $5.8 billion in FY18 due to lower fuel sales.

Bunnings (Australia & New Zealand) same-store sales grew 7.8% in FY18 (FY17: 7.3%) while total revenue increased 8.9% to $12.5 billion.

Kmart achieved comparable sales growth of 5.4% in FY18 (FY17: 4.2%) while total sales grew 8.0% (FY17: 7.9%). Target comparable sales growth continued to decline, -5.1% in FY18 (FY17: -14.9%) and total sales growth of -4.7% (FY17: -14.5%). Combined revenue was up 3.6% at $8.8 billion.

Officeworks does not provide same-store comparisons but revenue grew 9.1% to $2.1 billion. This includes the opening of six new stores and online enhancements, including 2-hour click-and-collect, to combat competition from Amazon.

In the Industrials division, Chemicals, Energy & Fertilizers (CEF) revenue grew 11.7% in FY18 to $1.83 billion; Industrial & Safety declined 1.5% to $1.75 billion; and Resources (now sold) declined 3.3% to $1.69 billion after Curragh mine was sold in March 2018.

Margins

There were substantial impairment charges in FY16 and FY18. If one excludes these significant items, net margins stabilized at 4.2% in the last two financial years.

Net Income (adjusted) % of Revenue

FY16 includes the following significant after-tax items: $1,249 million non-cash impairment of Target; $595 million non-cash impairment of Curragh; and $102 million of restructuring costs and provisions to reset Target.

FY18 includes an after-tax impairment charge and loss on disposal of $1.4 billion in respect of Bunnings/Homebase UK; $300 million non-cash impairment of Target; and $123 million gain on disposal of Curragh.

Return on Capital Employed

Wesfarmers are known for their disciplined capital budgeting and have demonstrated their willingness to shed underperforming assets.

FY18 Return on Capital Employed by Segment

Comparing return on capital (ROCE) to the actual allocation of capital, Coles is the elephant in the room, with ROCE of 9.2% in FY18 while absorbing almost 64% of group capital.

FY18 Capital Employed by Segment

Return on capital employed by Department Stores and Resources is inflated by impairment charges in FY16 and FY18, while the Bunnings/Homebase UK misadventure is excluded from the above capital allocation.

Department Stores and Officeworks are unlikely to form part of the group’s long-term plans but there is little opportunity for a sale at present. Target faces a declining market, while Amazon is expected to challenge Officeworks dominance in office supplies and stationery.

Industrial & Safety also failed to achieve meaningful returns on capital. With Resources gone, that leaves Bunnings and WesCEF as the likely last divisions standing.

Earnings per share

Earnings per share declined in FY16 and FY18 because of impairment charges.

Earnings per Share and Dividends

Dividends were maintained at 223 cents in 2018 (2017: 223 cents) and are fully franked.

Cash Flow

Free cash flow is reasonably strong despite recent losses.

Net Income & Free Cash Flow % of Revenue

Capital structure

Net debt is relatively low at 15% of equity and should improve further with post year-end disposals.

Net Cash/(Debt) % of Equity

Weaknesses

Conglomerates used to dominate stock market listings several decades ago but inefficient management structures and poor capital allocation led to their almost complete extinction.

Coles revenues are resilient through the economic cycle but margins will remain under pressure from Woolworths/Aldi competition.

Bunnings is susceptible to fluctuations in the property cycle, with current declining home prices a warning sign.

Department Stores are susceptible to the economic cycle, while Target also faces a shrinking market.

Officeworks can expect fierce competition from Amazon.

Valuation

We expect that the Coles spin-off will realize $18 billion at an EBIT multiple of 12 (Credit Suisse estimate $19.4 billion). We value the remaining divisions at an EBIT multiple of 8 (before tax cost of capital of 12.5%) apart from Bunnings at an EBIT multiple of 10, giving a total value including Coles of $36.60 per share.

With dividends of $2.23 (a 4.3% yield) estimated to grow at 4% in the long-term, we project annual investor returns of 8.3%, or 10.2% after allowing for franking credits.

Technical Analysis

WES broke through resistance at $50 after lengthy consolidation above support at $40. Momentum rose to 22.6% while Trend Index held above zero since November 2016.

Twiggs Momentum & Trend Index

Breakout above $50 was followed by retracement to test the new support level. Rising troughs on 21-day Trend Index indicate that respect of support is likely.

21-Day Trend Index

Conclusion

Hold. Wesfarmers has indicated that the Coles spin-off will be completed by November 2018. It would make sense to wait for the spin-off before deciding whether to invest further or divest.

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above company.

Sources

1 FY18 Results Presentation
2 Presentation, 16 March 2018
3 BBC News, 25 May 2018
4 Analyst Note, Johannes Faul, 15 August 2018, Morningstar

Capital spending on the rise

Just released July 2018 manufacturers’ new orders for capital goods, excluding defense and aircraft, show that the recovery is gathering speed.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft

Any fears that easy money has undermined capital budgeting restraints — and that the economy is entering the final heady stages of a boom before the bust — can be dispelled by adjusting the above graph for inflation.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft adjusted for Inflation

Adjusting manufacturers orders by the GDP implicit price deflator shows that the recovery in capital spending has barely started and is a long way from the excesses preceding the Dotcom crash and the GFC.