Themes For December

31 December 2015

After an uninspiring start to the month, the rally to the end of December generated a month end return of 2.5% for the ASX 200. The relatively small “Santa Claus Rally” saw our market outperform many of the international bourses that returned small losses to round the year out.

Key themes to play out in final month of the calendar year were divergent monetary policy adjustments and the already flagged transition of the Chinese economy away from being centred on exports and capital investment, to rely instead more on domestic goods and services consumption.

The European Central Bank (ECB) kicked off the month by lowering the deposit rate by a further 0.1%, extending the negative rate to -0.3%. It also extended its asset-purchasing program by 6 months to March 2017. Just two weeks later The Fed finally began the much anticipated tightening of monetary policy with a 0.25% increase to the official federal funds rate from a range of 0-0.25% to 0.25-0.5%. While the move had been flagged by The Fed for some time, the significance of the rate rise is not to be understated with it being the first increase since July 2006. The move is a sign of confidence in the underlying fundamentals of the US economy and its future growth prospects although The Fed is also conscious of the fact that increases to the official cash rate now will leave it with greater capability to stimulate the economy should there be further downturns in the future.

Interest rate moves greatly affect currency direction. While the U.S. have started tightening interest rates, the ECB, Bank of Japan, and People’s Bank of China all continue easing. This inevitably leads to upward pressure on the USD creating headwinds for companies in the US.

The Chinese Government has ambitions to grow its internal consumption of goods and services. With capital investment and export trade showing signs of slowing, the challenge for goods and services to bridge the falling gap in GDP growth is a difficult one. This transition will play out slowly and will likely be a bumpy ride. In January, China is expected to report “weak” quarterly economic growth of just below 7% – a growth rate envied by most nations. Nonetheless, it highlights a slowdown in their economy as capital investment and the property market begin to come off.

With oil prices at the forefront of the minds of investors, below is a pertinent piece written by Gareth James from Morningstar on 18 December 2015, helping to explain the current dynamics in the oil market.

Oil Price Outlook: Stage Still Set for Long-Term Recovery, but Near-Term Risk Elevated
The downward pressure on oil prices has continued unabated in the past few weeks, raising the same critical issues for investors trying to find value and understand downside risks amid the current industry crisis. We remain convinced that a handful of compelling opportunities exist for long-term investors. However, we continue to caution that tremendous uncertainty exists as to how oil prices will trend until industry fundamentals improve, which is likely to be a drawn-out process that doesn’t begin until the second half of 2016. Accordingly, investors should be discriminating in their stock-picking and prepared to weather additional volatility.

The past few weeks have seen multiple negative developments with respect to the near-term outlook for oil prices: OPEC maintaining current production levels, Iran announcing its intention to bring new supply on line sooner than previously expected, and U.S. output being revised higher. Taken together, the coming six months now look worse, and continued inventory builds through the first half of 2016 could further pressure oil prices.

Although further price declines are possible, it is worth stressing that Brent prices below $50 per barrel are sufficient to ensure the necessary capital expenditure cuts occur to prevent global production growth in 2016. Combined with demand growth, the market should balance by late 2016.

With the market set to balance then, what could trigger a further sell-off? The most likely culprits include storage levels becoming stressed from early 2016 inventory builds, oil production surprising to the upside (yet again), or demand growth slowing. Where oil prices bottom is anyone’s guess, but since they are already well below the level necessary to stymie production growth, inventory levels, need for higher-cost floating storage, refinery utilization, and fear are more likely to drive price movements than long-term fundamentals such as oil production costs.

In the likely event that OPEC and other non-U.S. production doesn’t decline in 2016, how U.S. output trends next year is likely to be a critical determinant of when crude markets eventually come back into balance. The further oil prices fall in the near term, the further U.S. production will fall in the longer term. The latest fall in prices has set the stage for companies to announce further cuts to their already sharply reduced 2016 capital budgets in the coming months. While this will take time to make a difference to global crude markets, we’re increasingly confident that U.S. output will be on a downward trajectory until there is a meaningful increase in industry activity, which cannot happen with oil prices anywhere near current levels.

The plummeting oil price over the last 12 months

We currently project U.S. oil production will decline 10% in 2016, assuming West Texas Intermediate averages $50 a barrel. But If WTI remains below $45 for all of 2016 (as futures currently project), activity will remain moribund and production declines could be greater. Given that it will take six or more months of substantially higher activity levels for U.S. production to begin growing again, we expect output to decline in 2017 as well. It’s taken longer than originally expected, but low prices will begin to have a meaningful impact on output in 2016.

While the United States is bearing the brunt of near-term supply adjustments, the stage is being set for non-U.S. volumes to eventually be affected by the collapse in industry investment; $100 billion-plus of oil and gas projects have been deferred or cancelled because of weak oil and gas prices. A dearth of new project sanctions during the past 15 months means there is a looming cliff in planned start-ups in 2018. While this cliff remains a ways off, the long-dated nature of nonshale oil means new sanctions are required in 2016 to complete a project by the end of 2018, at the earliest.

Our key takeaway: Low oil prices are having an impact on non-U.S. production that is not reflected in today’s production figures, and that impact will become increasingly severe the longer the downturn continues. The overused cliché is nonetheless accurate: The cure for low oil prices is low oil prices.

Australian Stock specifics:

Positive Contributors

Aristocrat Leisure (ALL, +19.6% for the quarter) – continued its recent strong run and was a positive contributor to portfolio performance for the quarter. As we discussed in a recent report, the company is now well advanced on its five-year turnaround plan under CEO, Jamie Odell. As part of this turnaround, ALL has invested heavily in product content across its various business divisions. As a direct result of this investment, ALL appears to be gaining market share in the key machine category in the US and Australia, growing its social or ‘app-based’ games at a healthy rate and finally, the acquisition of VGT last year appears to have been integrated seamlessly into the ALL fold. These factors were all evident in the FY15 profit results in November, where ALL delivered a 79% boost in profits versus the prior year, solid cash flow result and a positive outlook statement.

Super Retail Group Ltd (SUL, +28.1% for the quarter) – added value to the portfolio, buoyed by a trading update at the AGM in late October. SUL reported solid sales growth in each of its retail formats: automotive, leisure and sports, together with progress on various internal initiatives such as the restructuring of the ‘Ray’s’ format. SUL’s internal or ‘self-help’ initiatives are a key element in our investment thesis, and hence it’s pleasing to note the progress also being made on various supply chain, IT and warehouse initiatives SUL has been investing in over the last couple of years. These will make the business more efficient, release inventory (and cash in the process) and allow scope for future growth.

CSL Limited (CSL, +18.1% for the quarter) – shares in blood plasma producer, CSL, were the top contributor to performance for the period. Now a $48bn company, CSL has grown strongly over many years, benefiting from ongoing demand growth for its mainstay plasma products. At the same time, CSL has invested heavily in research and development (R&D), for both its mainstay blood plasma products, but also ‘specialty’ products for niche diseases, flu vaccines and more recently cancer treatments – the latter mainly with larger drug company partners. The next two years will, however, bring what CSL is hoping is a step change in new product launches with CSL aiming to release two new ‘recombinant’ or bacterially grown products for treatment of haemophilia and related conditions. These ‘new’ products aim to reduce treatment frequency by increasing drug life in the body and also lowering the complication or reaction rate from continued dosing these patients typically suffer from. Our positive view on these new products has been a key reason behind our large holding in CSL.

Underperformers

Origin Energy (ORG, -11.9% for the quarter) – continued weakness in the oil price weighed on the oil sector with ORG, in turn, weighing on portfolio performance. It has been a torrid year and a half for the energy sector globally with oversupply, geopolitical concerns and modest demand growth contributing to oil price weakness. The oil price has fallen from a peak of US$115 in 2014 to end 2015 in the low US$30’s. Our somewhat contrarian view at this stage is that oil prices will improve over the next couple of years as annual production declines occur across the whole oil industry, together with the US$250bn or more of future projects and associated capital works that have been cancelled in recent times, lead to a reduction in global supply. Although the outlook in the short term remains unclear, on the basis of our medium-term view we have been cautiously buying stocks such as ORG into the weakness. That said, we remain cognisant of the very strained Middle East geopolitical outlook which could prompt more short-term oil pain.

iSelect Limited (ISU, -24.9% for the quarter) – shares in ISU remained under pressure, with investors concerned about recent management turnover. Although an indicative, non-binding bid from Providence Equity Partners (a US private equity firm) remained on the table during the quarter, investors were clearly discounting the probability of a formal bid materialising that would, in turn, be acceptable to investors and the board. This discount was somewhat justified in December when ISU confirmed the bid would not proceed. Providence apparently remains interested, however, were unwilling to commit to a bid price ahead of further due diligence and as such, the board closed the process. Our recent meeting with management highlighted the broad opportunities ISU is pursuing across energy, car insurance, telecommunications, life insurance and mortgages. Should ISU be able to gain a small market share in any of these segments, the upside to ISU profits and share price should be attractive. Although ISU has had a series of management changes since listing, we continue to believe the fundamentals of the business and the medium-term opportunity remain sound. Finally, and on a positive note, ISU has also announced details of up to $50m in capital management initiatives, commencing with a 10% share buyback in December.

QBE Insurance Group (QBE, -2.3% for the quarter) – was weaker during the quarter and detracted from returns. The weakness was driven by commentary at the AGM, with QBE flagging softer premium growth in some of its business lines and insurance margin pressure. Irrespective of the market weaknesses highlighted, we have been impressed by cost efficiencies delivered by QBE in recent years and expect there is more to come. Further, QBE has also made major strides in improving the quality of its capital position and reducing the risk associated with its insurance book. Looking forward, QBE also has material exposure to rising interest rates which, given the likelihood the US Federal Reserve is about to raise short-term rates for the first time in 10 years, and assuming some flow through to longer-dated interest rates – to an extent this has already started – QBE is well placed. Finally, after many years of shrinking the business and focusing internally, QBE management is able to target growth across its businesses by acquiring specialist underwriting teams, something that would be well received by investors.