Two ugly ducklings that could turn into swans – FXJ, MYR

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 In this section we look at two stocks that are unloved but have the potential to come good. Recent takeover rumours have spurred investor interest in these stocks which now have the potential turn into swans. When assessing these stocks, we take into account the downside and upside risks and see whether both are worth adding to your portfolio. We also look at company’s fundamentals, technicals and thematics.

 Fairfax Media (FXJ) – This week the media giant became the centre of takeover speculation after private equity group TPG Capital quiety hoarded shares in the company on Monday night. Roughly 18.5 million shares were exchanged on Monday and another 17.13 million on Tuesday giving the private equity company a 5% stake. Due to FIRB regulations and national interest concerns a shareholder cannot own anymore than 5% and any holdings just shy of that figure aren’t required to be disclosed. But that hasn’t stopped the rumour mill. Experts say TPG Capital is considering a potential tilt towards either the entire company or just the Domain business, which is pretty much the cash cow of Fairfax. We think Fairfax is a buy just on takeover speculation. TPG Capital would need to lob a 10%-20% premium if they were to takeover the company. That premium would be a neat little profit. Even if it were to buy Domain Group it would have to offer quite a premium as well. Whether or not it gets approved by FIRB, won’t matter because we’re in it for a short term trade. But on that topic, FXJ isn’t a bad investment even for investors looking to hold it for the longer term. The company has a solid balance sheet with no debt. It trades on a PE of 16.65x and has a rising ROE. Its yield is 5.37% which is good. On the StockOmeter it reads 51 which is “Not Bad”. Its rating is a little low because of its longer term trend. On the chart, FXJ looks toppy. It’s hitting its upper resistance level and has been stuck in this channel for quite some time. A takeover offer from TPG could cause a break out but if there isn’t any other catalyst, we would hold off from buying FXJ as an investment based on the charts. It’s simply overbought. The RSI is at 83 and well in the overbought area.

  Myer (MYR) – This is another stock that has been doing the rounds in the takeover mill but this one’s more Solomon Lew playing games than an actual genuine takeover. Think back to 2014 when Myer was on the front of every newspaper running headlines like “Bidding war tipped for troubled Myer” or “Myer could have a new owner by Christmas”. Turned out, it was just Solomon Lew doing what he does best. Like he did with Country Road (CTY) and David Jones (DJS), he created a rumour storm of a ‘potential’ tie up between MYR and PMV. He quite ingeniously built up a blocking stake in DJS, preventing Woolworths from taking it over. Quite a headache he was. He used his barricade in DJS to force Woolworths SA to buy the remainder of CTY. This then allowed Woolworths to takeover DJS albeit at quite a cost. They paid $212m for his DJS stake and $209m in CTY ending a 17 year battle. A 17 year blocking stake preventing anyone else from taking over Country Road. And now he’s at it again building up a 10% blocking stake in MYR to royally infuriate Woolworths SA who have been hovering around Myer like a seagul. Check mate. Smart move by Lew, always ahead of the game. He’ll use his blocking stake to again force a good premium out of Woolworths SA. Hats off to him. You’d have thought Woolworths SA might have learn’t the first time around. Apparently not.

 So where does this leave us with Myer? If you read back a few weeks, we actually wrote up Myer and bought it for the Ferrari portfolio for a punt that the company would beat expectations and a short covering rally would ensue. We got it half right. It was a mixed result. The company did beat NPAT expectations but missed on like for like sales. Shares fell to $1.08 on Thursday but have bounced back. Then we sold. Doh! Hindsight is a lovely thing. Whilst its sales figures weren’t anything to talk about, Solomon Lew’s share grab renews investor interest in Myer. The real news is if there is another suitor lurking in the midst that may genuinly be looking at a possible takeover.  Or who knows, Lew might on the off chance decide to make a full bid for the company. Either way, Myer is in the hot spot right now with a register loaded with short sellers. We’ll know soon enough, whether it’s Lew or the identity of a mysterious bidder and their intentions. For a stock that’s been beaten down, it’s only upside from here. We think MYR is a buy.

 

A couple of stocks that are about to run – ITD, LVH

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 In this section we look at two stocks that we think are about to sprint off. For one reason or another these two stocks have caught our attention and we think the upside risks are attractive. When assessing both stocks, we look at the company’s fundamentals, technicals and thematics and whether the stock is worth adding to your portfolio. However we must advise you that these two stocks carry significant risk. So for the traders only. ITL Health Group (ITD) – Is another biomed company. It develops, manufactures, distributes and sells innovative medical devices, medical procedure packs and medical instruments for the human and animal global healthcare markets.  ITD’s core strategic businesses are broken up in to 3 areas – ITL BioMedical, ITL Healthcare and ITL Health test. ITL Biomedical manufactures a range of biological safety sampling devices for the human and animal global healthcare markets. ITL Healthcare develops medical and surgical devices, including procedure packs and specialized monitoring kits. ITL Health Test provide direct to consumer pathology testing i.e. diagnosing major chronic diseases. ITL currently holds 48 patents and is selling into 55 countries. The company posted a positive set of 1H results. NPAT was up 104% to $2.4m and Revenue was up 11% to $17.5m. It has cash of $1.4m and borrowings of $6.4m. The company’s flagship products are specialty products for the global clinical, blood banking and microbiology markets. In 2014 it began to focus on the global potential of its products in the Blood Culture Testing market. It was the right move which saw a 22% rise in sales for FY16 and 27% growth in 1H17. The market is in a growth phase because of an increase in the number of sepsis cases, rapidly ageing population and a growing recognition of the need to test blood samples for the presence of bacteria. Currently the market leaders are bioMerieux, BD and Thermo Fisher.

 ITL announced a record February in which it hit its highest monthly revenue and profit in its 23-year history.  ITL BioMedical and ITL Healthcare both achieved record months. It saw an increase in sales of its IV Starter Kit and ITL BioMedical began initial supply of products under the global, multi-year distribution agreement for its SampLok Sampling Kit with bioMérieux. Management expects “a strong result for the full financial year even allowing for some seasonality in the 2nd half year.” The company expects significant growth in first half 2016/17 with EBITDA up 54% to $2.5m. It also expects growth to come from SSK sales anticipated, already one of ITL’s biggest profit generators.  On the chart the stock is in a solid uptrend formation and has recently broken out on the upside. We recommend traders look to buy at these levels. It’s early days for the company. If its February sales are anything to go by, we’re confident that it can achieve its FY growth targets on the back of sustained sales growth of SSK product.

 Livehire (LVH) – Is a digital disruptor focused on recruiting employees through its platform. It can be described as the Airbnb of recruitment in that it provides an interface between talent and employers. We love the Livehire story, in fact we last wrote about the company last year – 20 August 2016. We said back then that LVH showed a great deal of promise since its IPO in June 2016. The stock does bear a high level of risk as there is no guarantee at this stage that the company will become viable. However, its high growth potential could mean that investors that are happy to harbour the risk and catch this stock early may be rewarded with high returns over the next few years. We think it’s a brilliant business that is set to disrupt the HR industry and has huge potential. It’s really not a matter of if, it’s a matter of when it will be adopted. When it does, it’s can be done globally. This is the reason why we think the company has so much promise and traders should be buying at its current level. The business is kicking goals and has positive momentum. But – we recommend only to invest in LVH only for those willing to take on a high level of risk. On the chart, the stock has rallied rather hard since listing but its only early days in the stock. LVH is in a solid uptrend formation and is making higher highs. We recommend buying on this momentum. LVH recent signed up two cornerstone clients for its cloud-based recruitment platform, Laureate Universities International and TAFE Queensland Brisbane. LiveHire earns revenue as clients grow Talent Communities to an optimal size of 5-10 times the number of employees and pay $0.50 per individual Talent Community Connection per month. TAFE Queensland Brisbane has over 40,000 local and international students getting their education and training each year and Laureate employs 50,000 people globally and provides services to 1 million students across the globe. TAFE Queensland Brisbane Talent Community was launched across the whole organisation, providing a strong growth channel into the six divisions of TAFE Queensland. The company also recently announced a $12.5m capital raising to accelerate growth. Shares were placed at $0.44 each and are now trading at 55c. This will ensure the company is fully funded to expand its operations with $18 million cash in the kitty with an additional $3 million expected in CY2017 from R&D rebates. On the chart, LVH looks particularly attractive. The stock has been in a solid uptrend formation since it listed and has been making higher highs ever since. It is however looking a touch overbought and heading in that direction with the RSI at around 69. MACD is positive. All in all, we like the story and think there is positive upside potential now that the company is funded and ready to expand. It’s a buy but for traders only.

 

Invesco Responds to Paradigm Shifts in Markets by Applying Non-Traditional Approaches

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This week Invesco invited us to a presentation about their non-traditional approach to investing specifically relating to their Global Targeted Returns Fund. National Key Account Manager, Sam Sorace, discussed past performance and what the fund has achieved since inception. The fund manager for the Multi-Asset team, David Millar, then went on to discuss how the world has changed and what this means going forward for multi asset investors. But first a bit of background into the Global Targeted Returns Fund. The fund has a target return of cash rate plus 5% pa over a three-year rolling period, where cash rate is measured by the Bloomberg AusBond Bank Bill Index. Although the fund is a targeted return fund and obviously seeks to meet this return objective, Invesco places a high priority on minimising volatility of returns. Hence the fund has volatility targets to achieve half the volatility of global equity markets which grants investors a greater sense of stability. To achieve these volatility targets the fund implements high risk diversification and has an unconstrained ideas approach with no asset allocation targets. The fund has a return of 3.77% pa since inception to 28th February 2017 and has an MER of 0.95%. So looking forward, where to now for the fund after an eventful 2016. David gave us an insight into how the fund views future global growth. He emphasised that nominal GDP growth for Australia remains low and sluggish and will continue in the medium term with inflation to remain below target. He expected growth expectations to be revised particularly for bond yields which have been recently rising but are still relatively low. He went on further to suggest a fragmentation of global markets growth due to factors such as national protectionist policies and that we should view markets separately rather than the vague view that global growth and inflation is low. The main reason for sluggish growth across global markets has been attributed to prolonged policy uncertainty. This was clear in late December as markets rallied when there was a sense of decisiveness regarding policy due to the election of Donald Trump. But how long can markets continue this rally while policy uncertainty continues to linger, particularly in Australia. The fund also challenges conventional bond-stock allocations stating that the strategy relies ona negative correlation in returns between bonds and equities. Using historical evidence, it was shown that as bond yields rise, typically above 5%, the correlation between bonds and equities shifts from negative to positive. This shift in correlation becomes an issue for investors that are seeking diversification benefits from set bond and equity allocations.Taking all these factors into consideration, the fund uses an ideas based approach to build its portfolio. David believes the only way to achieve true diversification is to break away from the focus on asset class constraints. The team aims to identify around 20-30 good long term investment ideas across all asset classes that are expected to benefit from economic themes in a 2-3 year horizon. For each new idea, the fund considers how much independent risk each idea poses and does that offset risks of other ideas within the fund. The portfolio is continuously stress-tested and subject to scenario analysis to quantify the downside risk of these ideas. Some of the types of assets the fund invests across include currencies, corporate bonds, volatility instruments, inflation products and commodities.

 Unconventional View: Invesco had a mixed last quarter of 2016 with two positive performing months but a negative return in November. The fund has performed well from the US vs Australia interest rate position as rates have been rising in the US while remaining stagnant in Australia. Into 2017 the fund has continued to deliver with a strong February performance of 1.38% which was 1.25% above the benchmark. The fund has met its volatility objective with volatility of 5.06% in February below 50% of global equity risk. Our favourite chart from the presentation is shown below that really highlights the role the GTR fund plays in an investor’s portfolio. The chart shows the performance of the GTR fund (blue) against global equities (pink). While both have followed the trend line for cash rate plus 5% pa, the key differences lie in the volatility. We can see clearly global equities have had far greater fluctuations than the returns from the GTR fund. Not only is this reduced volatility important for stability of the portfolio but it actually improves long-term performance by preventing investors from selling out at market lows due to high volatility. While the end of chart shows global equities to be higher than the GTR fund, consider an investor that may have risk controls such as stop losses for their portfolio. Such an investor may be inclined to sell out some of their holdings at the point indicated where global equities have declined rapidly. The result is that the investor would realise losses at the bottom of the decline and would most likely underperform compared to the GTR fund’s performance. We like Invesco’s ideas based approach to portfolio construction and find it is highly applicable in such an uncertain investment environment. Not only is it their consistent performance in line with their target return but the approach to equally prioritise volatility of the fund leading to very stable performance of the fund which is invaluable to investors during such volatile times.

3 stocks from the herd – CLQ, MTS, PMV

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In this section we provide readers with three stocks that have attracted the interest of the broking community or the ‘herd’. Broker recommendations tend to be biased and highly optimistic. We try and breakdown these barriers and give our own honest opinion. It is important to keep in mind that technical analysis is only one part of the investment process and any recommendations do not give consideration to the underlying fundamentals of each business.

Clean Teq Holdings (CLQ) – Current Price $0.98 – Is the owner of the Syerston Nickel/Cobalt/Scandium Project in NSW, Australia.  Syerston’s unique mineral resource, when combined with Clean TeQ’s proprietary ion exchange extraction and purification processing technology, positions Clean TeQ to become one of the largest and lowest cost suppliers of key cathode raw materials to the lithium-ion battery market – nickel sulphate and cobalt sulphate.  The Syerston Project will also produce significant quantities of scandium for the next generation of light-weight aluminum alloys for transportation markets.

Broker View: Macquarie (OUTPERFORM $1.50) – The broker has quite a positive write up on the company. CLQ recently raised $81m to fund the Syerston development. This fast tracks the project and removes any near-term funding risk. It also helps project completion prior to the expected date. The other thing is cobalt price. Macquarie sees prices continuing to rise and will provide upside support going forward

Unconventional View: We agree with Macquarie. Firstly what does CLQ do? Its share price is up almost 600% in the year. It must be doing something right. Shares have moved from 12c to 80c all on the back of the electric revolution and its flagship Syerston project which is rich in cobalt, nickel and scandium. Forget lithium, it’s all about the cobalt. Rising demand for batteries in electric cars, renewable energy storage such as Tesla’s Powerwall Home Batteries and portable devices like iPhones and Laptops has caused prices in not only Lithium to rise but in Cobalt as well. Strangely Cobalt is yet to receive the wide spread public notice that lithium has in recent years, even though lithium-ion batteries containing more cobalt than lithium. In simple terms, a battery contains an anode and cathode. Most lithium-ion batteries are made using a cathode that’s a mixture of lithium cobalt oxide. More than half the supply of cobalt comes from the Democratic Republic of Congo of which China’s China Molybdenum owns 56%. Which means most of global cobalt production goes to China. The battery industry uses 42% of global cobalt production in its batteries. So you can see why cobalt has risen in price, it’s scarce. Teslaalone needs roughly 6% of world cobalt production for their batteries. This is where Clean TeQ fits in. It is developing a world-class Syerston Cobalt Project in NSW called the Syerston project. It has one of the highest grade and largest cobalt deposit outside of Africa. The mineral resource when combined with Clean TeQ’s proprietary ion-exchange extraction and purification processing technology has the potential to meet global Cobalt demand required for the lithium-ion battery industry. A definitive Feasibility Study is underway for the Syerston Project due for completion in 2017 Q4.  The DFS will assess the economics of a large scale project producing battery grade nickel and cobalt sulphates – key raw materials required by the lithium ion battery sector – and by-product scandium oxide. We like the underlying story, electric vehicles and battery storage is here and only going to grow exponentially in the coming years. If CLQ can effectively supply Cobalt to this market, the upside potential is huge. Cobalt was one of the best performing metals in 2016, with price increasing ~50% over the year, we think this will steady increase from here on in. On the chart CLQ looks pricey having rallied so hard. But it’s a speculative stock and one that will move very quickly on a positive announcement. It has pulled back a touch, so if you’re comfortable taking on a little risk now is a good time to jump in. This is one for the traders only.

Metcash (MTS) – Current Price $2.44 – Is a wholesale distribution and marketing company specialising in grocery, fresh food, liquor, hardware and automotive parts & accessories. MTS operates in Australia and a smaller liquor business in New Zealand. Its business are – 1,365 IGA branded stores, 117 Foodland stores, 484 FoodWorks stores and 245 Lucky 7 (convenience) stores. Within the Convenience division there are Campbells Wholesale and C-Store Distribution which service businesses around Australia. It has Australian Liquor Marketers (ALM) who are a wholesaler supplying more than 12,000 hotels, liquor stores, restaurants and other licensed premises across Australia. ALM also supports independent retail brands through Independent Brands Australia (IBA) which offers marketing support and variety of retail services. The four national IBA retail banners are Cellarbrations, IGA Liquor, Bottle-O and Bottle-O Neighbourhood. MTS also covers the hardware space via Mitre 10.

Broker View: Ord Minnett (LIGHTEN $2.10) – The broker has quite a bearish view on Metcash. It says the integration of the Home Timber & Hardware acquisition is not progressing well. It hasalso painted a rather gloomy picture of the sector’s outlook saying the company’s share price doesn’t take into account the risks associated with the food and grocery division.

Unconventional View: We disagree with Ords. Everyone seems to overlook and underestimate MTS and its IGA supermarket solely because of the onslaught of Aldi and a recovering Woolies. But there’s so much that’s positive about the company that people don’t see or factor in. Sure its IGA supermarkets isn’t firing on all cylinders caused by a massive Aldi-led shake-up of the grocery sector. This has put pressure on MTS’s Food and Grocery sales which fell 1.2% to $4.49bn and supermarket sales fall 1% to $3.7bn. But there are a few things that the company has done which will see a better FY result. Ritchies IGA has gone gourmet. Stores have been transformed into up-market, gourmet supermarkets with artisan bread and bespoke peanut butter. The first store that reopened experienced a 50% spike in sales in the first week of opening. Convenience store earnings are also set to recover after cost-cutting measures are implemented. But there’s another angle that’s often overlooked. Shares in MTS are roughly 10% short sold and rank in the top 10 most shorted stocks. Shares have already doubled from its low of $1.01 to its current share price of $2.47. It’s still a far cry from its high $4.50 high in 2010. What is interesting is CEO Ian Morrice’s remarks that the worst may be over for the company after its 30% fall in earnings over four years. He expects earnings to rise driven by cost savings, a few additional days of trading, a recovery in the convenience business and easing price deflation. If you add in further growth from its liquor business which is performing well, plus upside potential from the merger of Mitre 10 and Home Timber & Hardware, we’re set for a positive FY result.

 Any upside will cause quite the short covering rally. FY forecasts are sitting at $177m which we think is conservative and doesn’t take into account the above positives. The fact is, most were expecting MTS to wither and die. It hasn’t. In-fact it’s returned a stronger and leaner machine. Sure it’s no Aldi… but it doesn’t need to be. People still like to shop at independent retailers. If MTS can maintain or even turnaround sales at its supermarkets, bring about some synergies from Home Timber & Hardware and maintain a solid liquor business, expect the positive price reaction to continue. The chart is looking particularly attractive. MTS has clearly reversed in trend and formed a short term uptrend. The stock is making high highs and on the road to recovery. MACD is positive whilst the RSI is looking a touch overbought. All in all, we think investors should be loading up on MTS now.

Premier Investments (PMV) – Current Price $14.33 – Operates number of specialty retail fashion chains in Australia, New Zealand, Singapore and via a joint venture entity in South Africa. PMV operates retail division through its subsidiaries Just Group Limited which operates seven brands including Just Jeans, Jay Jays, Dotti, Portmans, Jacqui E, Peter Alexander and Smiggle trading from more than 1,000 stores. This week it confirmed that it had secured a $100m raid on Myer (MYR) shares which gives it a 10.77% stake.

Broker View: UBS (BUY $17.00) – The broker has an optimistic view on the stock after it secured a blocking stake in Myer. Its intentions are not to lob a takeover. Whilst there is no talk of making a takeover bid, UBS sees it as a very positive move. It could bring synergies of well over $25m in revenues and gross profit.

Unconventional View: We agree with UBS. Reading an article in the AFR, analysts believe PMV could bump its earnings by up to 16% in 2018 if it acquired in Myer. Now it’s a hypothetical ‘what if ‘scenario, and Solly Lew has already said a takeover is not in their vision BUT Citi believe it could be worth roughly $1.50 a share based on a bid at 10-times Myer’s forecast EBIT or 16% earnings accretive. Now we’re pretty confident that Lew isn’t considering a bid but we all know the market likes to get carried away with rumours and speculation. The thing is the MYR acquisition really makes no sense. Lew is definitely up to something. Whether he sits on the stake for 17 years who knows. On the numbers PMV looks attractive. The stock is a little expensive in comparison to its peers when looking at its PE of 21.60x but it has a stable ROE. Low debt and decent yield. The company also posted a decent profit result with a slight rise in its 1H profit to $71.9m. Total sales revenue grew 7.1% to $588.6m. Whilst I’m not a huge fan of blue rubbers and pink pencil cases, Smiggle sales were up 26.4%. All in all it was a solid set of results. The chart is also looking attractive at these levels. The stock has dipped back and bounced off its support line, which is a really good entry point for those wanting to buy. RSI is not too expensive on 64 and MACD positive. 

 

Three steps and a stumble

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In the wake of last week’s interest rate hike by the US Federal Reserve and its admission of two more thisyear, investors, analysts and central banks around the world are shifting their policy stance and exposures in what could be the end of easy money.

 Last week’s hike marked a pivotal point in economic history. Whilst you may not think a US rate hike may be that significant, it really is. It creates a massive knock on effect throughout the rest of the world. Firstly, raising interest rates has an immediate ripple effect with foreign currencies. The US dollar is used as a benchmark against its future economic growth. When rates go up, it’s usually followed by an appreciation in its currency. US Treasury Bonds are the first to reflect changes in rates. The Treasury yield curve will move up to reflect an increase in rate. Other securities must then offer a higher return than the risk free Treasury rate. This causes investors to shift their money into the US to take advantage of higher returns. In turn this causes the dollar to rise. Aussie dollar will fall. Currencies in emerging markets will fall. But it’s much more than just that. The rate hike pretty much marks the end of the rate cutting cycle. The days of easy money will soon be a thing of the past. Three rate rises since December 2015 and two more on the way have prompted major changes in interest rates around the world.

US Federal Reserve rate rising cycle

 Here are some of the ripple effects caused by a change in the interest rate cycle:

US dollar denominated debt – Emerging markets Since the GFC, emerging countries have taken on loads of US denominated debt amassing some $3.3 trillion in just a few years. Countries such as Turkey, Ghana, Nigeria, Argentina, Brazil, Thailand, Vietnam, Brazil, and South Africa perpetually run trade deficits and finance their current account deficits by building up US dollar-denominated debt. When there is an interest rate hike together with a spike in the US dollar, you get a double whammy effect:the exchange rate between the emerging country and the US widens and the US denominated debt owed by the emerging country increases. The real risk here is that the debt becomes unmanageable. Not only does this occur, but it could also trigger a capital outflow where investors may shift money back to the US where rates are rising.

Falling currency – If the US raises interest rates while other global central banks maintain or lower their interest rates, then the return on savings is more attractive in the US than in other countries. This means capital flows from foreign countries to the US resulting in the dollar’s appreciation. This causes the exchange rate of other currencies to fall. It is good news for the RBA who won’t need to raise rates urgently with a falling Australian dollar. A US rate hike can be a pain for countries like China that will likely see an increased capital outflow. The outflow of capital from developing markets will in turn cause their currencies to depreciate further. When foreign investment into emerging countries starts to dry up it will effectively put the brakes on economic growth that relies on such investments. The countries most at risk of this are Turkey, Brazil, India, South Africa, and Indonesia. Australia’s cash rate is materially higher than the US rate. That makes Australian deposits more attractive so foreign investors will buy Australian dollars in order to take advantage of that “yield differential”.

US dollar denominated debt – Corporate As well as countries loading up on foreign debt, the same thing can be said about corporations loading up on US denominated debt driven by low interest rates. Easy money as it’s called. This debt now makes them vulnerable to future interest rate increases, resulting in higher interest repayments and rising debt levels. It’s a vicious cycle. 

Australian banks – Mortgage & property market – When rates go up, it’s usually a headwind for the property market. Any increase in US interest rates would mean that wholesale bank funding costs go up. The big four banks get a third of their funding from bonds and the remainder from customer deposits. Therefore bond rates affect the cost of money for all of us. Banks can’t really offset the increase in wholesale funding costs with rates charged on deposits because they’re so low. So what do they do? They pass on the difference to customers by increasing interest rates independently of the RBA. Last week NAB increased rates. This week WBC upped its variable rate for owner occupiers by 0.03% to 5.32% on principal and interest loans. For owner occupiers paying interest-only they will see larger hikes of 0.08% and their rate climb to 5.49%. It’s quite simple, banks are borrowing too and they are simply passing this extra cost onto customers. In reality our banks have been itching to raise rates and this gives them the perfect excuse to do so. You can only expect more of these out of cycle bank rate rises independent of the RBA.

US 10 Bond Yield chart All assets are priced off bond rates either due to their yield differential or funding via debt.

But here-in lies the problem: Melbourne and Sydney have gone bananas with investors and home owners snapping up heavily overvalued properties that they can only barely afford. What happens when interest rates revert to the long term averages? One in five homeowners will get themselves into hot water if rates start to rise. People tend to think that property prices rise forever and interest rates will stay low for quite some time. Wrong. They’ll get a rude awakening when they find out this week that rates have already begun to rise. Australian household debt currently stands at a record 187% of income with average household net debt now sitting at almost $250,000. A case of ‘Buy now, Pay later’. Here’s how bad it can get. A 2.5% rise in interest rates would push mortgage repayments on average up by $6,223 per year. It would also push mortgage interest repayments to 58% from 42%. With higher mortgage rates on the way, it will cause financial stress for many that own a house. It will dampen demand, and almost certainly put off new investors. It will however be a welcomed relief for a seriously hot property market that needs demand to cool and for prices to come off the boil. 

Lower commodity prices Many countries such as Australia are heavily reliant on commodity exports to support economic growth. Brazil and Russia depend on crude and gas prices, while Australia depends on iron ore and coal prices. There is usually an inverse relationship between commodity prices and the US dollar. So if the US dollar rises in value, commodity prices fall because they are denominated in dollars. When the dollar goes up, it means the commodities become more expensive for those who hold other currencies which has a negative impact on demand due to lower purchasing power and prices fall. Commodities are also traded in US dollars. So we could see further downward pressure on oil and gold. This is bad news for emerging markets because most commodities are in US dollars will generate less revenue in real terms. The Australian dollar is a commodities currency. That means it rises as commodities such as coal and iron ore rise. Iron ore makes up the bulk of Australian exports, so it’s little wonder that the Australian dollar is closely linked in to iron ore prices. Aussie ore must be purchased with Aussie dollars at the end of the day. As demand rises, so too does demand for the A$.

Stock Markets Rising interest rates are generally a headwind for stocks in the longer term but share markets do tend to climb for the first two years of a rising interest rate cycle. While there is no rule or definite correlation, in the past rising interest rates have spooked investors causing a sell off. There is an old Wall St adage ‘Three steps and a stumble’. That means watch out after the third interest rate rise, because stocks will fall. This is the third step, so we should see a stumble soon. The US markets is down 1.3% this week. We’ll soon know if the adage holds true. On the day of the rate rise both the ASX and Aussie dollar reacted positively. What the? Usually the rate rise would have seen the US dollar rise and Aussie fall. It could be that the absence of any surprise in the decision and expectations of three future rate rises that was pared back to just two, that may have caused the rise. Some even say that the false starts in September and October had many relieved that there was the hike and it was all priced in. Nevertheless, the norm is for higher US interest rates to put downward pressure on the share market because it becomes less attractive and the discount rate is higher.

The end of easy money The US rate rise marks the end of expansionary monetary policy and beginning of contractionary monetary policy. Expansionary monetary policy was used after the GFC to increase the money supply to lower unemployment, boost spending and stimulate economic growth. Interest rates tumbled to near zero. It worked a treat. Now it’s time to turn the tap off. Tightening monetary policy slows the rate of growth in the money supply in order to control inflation. The US economy is on a healthy footing as unemployment falls. As such rates need to rise to stop inflation from rising. What is for certain is that the 35 year old rally in the bond market is well and truly over. Whilst the interest rate cycle is definitely turned direction, it’s coming from a very low base and moving slowly. An article in the SMH talks about Macquarie conducting an investigation. The bank found that 18 previous Federal Reserve easing and tightening cycles since 1954 showed that rate rises particularly ones that occurred in the early part of the tightening cycle, were good for equities. Shares rose over 20% in the year after the first hike. Aussie shares rose during the start of a US tightening cycle at around 10% the following year. Going by that report, the start of a rate hiking cycle is a positive thing. However this is the third hike so the start of the rate rising cycle is maturing. Could it be that the next hike will see a market sell off?

Winners and Losers Winners – Banks stand to benefit from US interest rate rises as their net interest margin rises. NAB has already lifted its home loan rates citing increased wholesale funding costs in the bond market. NAB is expected to earn some $200m just from the increase. Westpac (WBC) has done the same with CBA and ANZ to follow suit. US rates also look favourably on QBE which is a winner from a rate hike. Why? Because QBE generates about a third of its revenue from the US and its portfolio is loaded with US bonds. So obviously a higher yield means higher returns. Tourism stocks such as Webjet (WEB), Corporate Travel (CTD), Mantra (MTR) and Sealink Travel (SLK) will benefit from a lower Australian dollar attracting tourists from overseas. Offshore earners such as Computershare (CPU), James Hardie (JHX), Ansell (ANN), Boral (BLD), CSL and Ramsay Healthcare (RHC) all benefit from a higher US dollar. Stocks in consumer staples, cyclical resources

Losers – It’s time to sell bond proxies. Income seeking investors bought companies that displayed bond market type qualities such as income and safety because bond yields were too low. As a result stocks like Sydney Airport (SYD), Transurban (TCL), APA Group (APA), Westfield (WFD) and Spark Infrastructure (SKI) saw increased demand as retirees bought these bond proxies for safe income. Telcos, infrastructure, pipelines, utilities and REITs were the main sectors. With bond yields on the rise, there will be a reversal of this bond proxy trade. As a general rule REITs, telcos and utilities all underperform in times of rising yields. Just by looking at the charts, you’ll see that these bond proxies have already started to pull back.They have to because they are sensitive to interest rate movements, demand high PE’s yet they trade on low ROEs. The best option is for retirees to switch back into fixed interest bond like investments or into cyclicals.

With easy money monetary policy now well and truly over, investors should adjust their portfolios in preparation for higher bond yields and interest rates. This means switching out of bond proxies and into cyclicals, offshore earners, banks and QBE. Goldman Sachs is forecasting the RBA to raise rates this year (November), which will more than likely be the catalyst for these bond refugees to start their exit. So why not get out before the herd exits? Well there’s one exception to the general rule: If Trump spends big on infrastructure, won’t that be positive for the sector? Whilst rising rates is usually a headwind for this asset class, the impact could be offset by Trump’s rebuild America will boost infrastructure related stocks. Despite this factor, Goldman Sachs says “With rates moving higher, bond proxies now look more expensive.” A 25% drop in bond proxy share prices wouldn’t be out of the question, if US 10 year bond yields rose to 3.83% from 2.5%. Whilst the general rule is – When rates are low, yields are hard to find, infrastructure stocks do well. The counter argument you may hear from some analysts is that most infrastructure companies such as Transurban (TCL) have assets that are inflation linked. So as interest rates go up, so does inflation which feeds directly into Transurban’s toll revenue which rises inline. Despite this, there will still be a sell-off as bond proxy investors worry about rising bond yields and switch. It’s a self-fulfilling prophecy. The other problem is rising rates makes it harder for these infrastructure companies to service their rising debt levels. In the end, investors hold infrastructure stocks because they’re rate sensitive. So when rates rise, these stocks will be sold for the same reason they were bought. They will usually pull back to their real valuations. Resources space are a good place to be. Think about switching into BHP, RIO, Alumina (AWC), South32 (S32), Bluescope Steel (BSL), QUBE (QUB) or Seven Group (SVW). Which-ever way you dice it, the days of easy money are over and the great bond market rally is now a thing of the past. Interest rates are set to rise and cheap money will now cost more. Safe haven bond proxy stocks such as infrastructure and property trusts might come under a bit of pressure as they lose their status.Bond yields are starting to rise not only in the US but worldwide. This ends a 30 year decline in yields. The Australian Government Bond has risen to 2.82% from 1.83% in August. The RBA has signalled that it will hold rates as is. No one is expecting the RBA to raise rates anytime soon, but next year it could become a reality. Our message to investors: Interest rates have already started to rise but are still low. You need to be ready to reposition your portfolio accordingly. Look for real earnings growth when selecting companies. An eventual rise will affect almost all sectors of the share market so remember ‘Three steps and a stumble’.

A couple of stocks that are down but not out

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In this section we look at two stocks that are cheap. These two stocks were once market darlings but have been smashed or have been overlooked by the market and are now oversold on all metrics and are starting to make a come-back. When assessing both stocks, we take into account the downside and upside risks and see whether both are worth adding to your portfolio. We also look at company’s fundamentals, technicals and thematics. Blackmores (BKL) – Current Price $115.73 – From market darling to perennial loser, the stock has gone from a 52 week high of $204.87 (April 2016) to a low of $97.91 (October 2016) all due to China clamping down on cross border e-commerce imports that had threatened the entire industry. On 11 April, BKL shares fell 20% after China revealed strict new regulations on importing products into the country. And it wasn’t just BKL that was hit, so too were Bellamy’s (BAL), A2 Milk (A2M) and Fonterra and other baby milk exporters. But something magical happened this week that caused shares in BKL, BAL and A2M to rally. It looks like China has delayed indefinitely its strict new-cross border e-commerce laws that sought to stop the flow of Australian vitamins, infant powder and cosmetics into the country. Hooray! It’s been a tough year for all three companies, especially Bellamy’s that has suffered from a glut of produce left on market shelves that hasn’t sold. But it’s interesting that the announcements have come just before Premier Li Keqiang arrives in Australia for talks on the FTA and trade barriers. Co-incidental? Maybe. Nevertheless it’s good news and a big win for BKL.

 China’s regulatory changes have been a huge overhang on BKL shares which were down -52% before this week’s backflip. Shares have rallied 17% this week. Now that this overhang has been removed, the vitamin trade can continue without the disruption of new licensing and labelling requirements but most of all, it removes the uncertainty and we call know markets hate uncertainty. Goods imported through cross border e-commerce platforms (Alibaba and JD.com) will be exempt from registration or labelling requirements. It looks like the Government has come to their senses and is trying to make trade as smooth as possible.Since the laws were first introduced in April 2016, the entire sell off has been a sentiment damaging exercise with investors fleeing China facing stocks worried that products would be prevented from hitting China. Now that this worry has been removed, we think the sell-off places these stocks in the attractive bucket. Sure BKL has already rallied but there’s still further upside remaining and a long way before shares return to its prior level.

On the StockOmeter the reading is 56, which isn’t a big surprise – Long term trend is down, ROE is falling (due to the ban) and yield is low. But we think BKL is worth a punt. The stock is a lot cheaper than before. It trades on a PE of 24.63x which is lot better than its PE high of 45.98x. The stock is down some 60% in the year and has been in a tumbling downtrend making lower lows. It now looks to be making a reversal having broken out on the upside, although it’s still very early days. This upside break out is a bullish buy indicator. RSI is at around 65 and getting to that overbought area. Investors might want to wait for a more convincing break out before buying.

TPG Telecom (TPM) – Current price $6.79 – In the same way BKL shares have fallen from grace, TPM suffered the same fate when the company voiced its concerns over NBN’s proposed costs. The telco unveiled at its results that the NBN’s costs were a lot higher than expected and will be too expensive. This means there will be a huge squeeze on profit margins all because the NBN is looking to recover its $40bn in capital costs. Shares fell 21% on the day of the announcement, and 43% over the 3 months that followed. This is all despite TPG releasing a strong result with organic growth of 10%. The market was bitterly disappointed with its forward guidance. TPG expects underlying EBITDA to fall between $820m-$830m 2016-17 which was well below consensus estimates of $884m. All due to the NBN. It was the first sign that Australia’s fixed-line broadband is facing a challenging path ahead. This all occurred back on 22 September. Whilst it’s wasn’t a Dot.com bust up or anything like that, the telco sector copped a beating. Vocus (VOC), Telstra (TLS) and Amaysium (AYS) were the other telco’s which were sold off as a result. VOC shares weren’t immune suffering similar falls.

  This week TPM share rose by roughly 5% following a bumper profit result that beat expectations. But it wasn’t just the result that impressed, chairman David Teoh has transformed the business to be able to expand and grow despite an upcoming profit margin crunch as the NBN launches. TPM lobbed a 1H underlying NPAT rise of 28% to $207.5m which was well above a consensus forecast of $197m. The telco also went ahead and reaffirmed guidance for FY underlying EBITDA to be $820m-$830m. The company also added 36,000 broadband subscribers. Combined with iiNET it came to 43k consumer broadband subscribers. Total number 1.91 million. Subscribers on NBN plans rose by 54k to 173k. The company also has 24k subscribers on its own fibre-to-the-building service. It is also building its own fibre-to-the-basement network which takes advantage of a loophole allowing it to compete with the NBN. It spans 500k apartments in city areas. Morgan Stanley has a Buy recommendation with a target price of $10.75. The broker says the telco has the best price in what is becoming a competitive landscape for broadband. It has actively reduced costs and benefits from the iiNET acquisition were the primary driver of the 1H result. Guidance was reaffirmed. The broker thinks this guidance is conservative.

We tend to agree with the broker. Sure there will a margin crunch in the 2H when NBN comes online, but we think the market is being too cynical and the sell-off is way overdone. TPM’s FTTB services will help offset the adverse impact of the ADSL to NBN migration. But more importantly, TPM wants to become the 4th mobile operator after Telstra, Optus and Vodafone. To do this, it needs to win the April auction for 700Mhz spectrum. Luckily Telstra won’t be competing. It already owns 1800Mhz and 2500Mhz. TPM also has an agreement with Vodafone Hutchinson to construct 4000km of fibre to Vodafone sites. This network could be the framework for TPM’s own mobile network. The network is tipped to be pricey at around $1.5bn, which TPM says it can fund without a capital raising. Either way something is brewing. We think TPM will likely go it alone and build their own network. It makes sense for them to do this. All in all, you get the feeling that TPM is quietly yet confidently working away in the background on something big. When the NBN launches, sure profit margins on broadband accounts will shrink, however we think the company will completely offset this with not its own FTTB network and possible mobile network. To add to it TPM is also rolling out a network in Singapore. TPM scored very similar to BKL on the StockOmeter – 54. PE is 15.41x and ROE is high but falling. Yield is OK. Debt is a little high. Short term trend is good but long term is bad. Similar to BKL, you can see the upside break out. It’s a little more convincing here. The chart is attractive and the break out throws up a bullish buy indicator. We advise those willing to take on a bit of risk, buy TPM at these levels. We believe the downside risks have been priced in and it’s only up from here.

 

2 stocks that are set to fly

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In this section we look at two stocks that we think look extremely good. These two stocks have caught our attention and we think the upside risks are attractive. When assessing both stocks, we look at the company’s fundamentals, technicals and thematics and whether the stock is worth adding to your portfolio.

Updater (UPD) – We think updater could be the next big thing. No seriously. This story caught our eye not only because of its disruptive technology but also because of its upside potential. First a bit about the company. If you’ve ever moved houses, you’ll know how much of pain in the backside the entire process is. There’s literally a million and one things you need to consider and no matter how meticulous you are, there’s always something you forget. That’s where updater comes in. The New York City based company has developed a platform to make it easy for the whole relocation process in the US. Updater’s web-based Mover Product helps people moving to (called “Movers”) organise and complete their moving-related logistics. Movers can gain access to the Mover Product through an invitation from a real estate agent, mortgage or title company, property manager or moving company. Real Estate agents partner with Updater to invite their clients, residents or customers to use the Updater Mover Product and to brand, customise and personalise the Mover Product experience for their Clients. So in other words, the platform connects a Mover with companies such as real estate agents, mortgage brokers, insurance companies and banks. It takes care of things like mail forwarding, logistics, removalists and record updating. It even looks after broadband and telecommunications. At the moment its focus is entirely on the US which is a massive market. Some estimate 17 million moves once each year and nearly everyone hates the process. In April 2016 the company had a 4.25% stake of the market. It intends to hit 15% market share by the end of 2017.

The company has some US$33m in cash with no debt. Tick. It has deep seeded relationships with real estate agents around the US. Over 650 to be exact. These partnerships are what forms the foundation of the network effect. By offering value to households, real estate companies, and related businesses it starts the wheel turning. But here’s where the real money is: US businesses spend billions each year trying to find and communicate with Movers so that they can sell their products. Updater hand delivers these clients directly to these businesses. The revenue potential is huge especially in the insurance sector, which can be up to $100m per year. So its primary revenue comes from the value it provides to businesses looking to market to Movers. It recently announced a pilot with Liberty Mutual Insurance which is a large property insurer in the US. It’s a 12 month trial that will establish whether the platform helps the insurer reduce their churn rate on Movers who change address. To put it in one sentence, Updater is the one stop shop for Movers relocating and businesses looking to provide the services to these Movers.

The company’s share price is hovering around the 69c level after listing at 20c. It recently spiked from 40c to 69c following a positive result in the insurance pilot mentioned above. The highlight of the announcement was pre-Movers exposed to the Updater Communications platform purchased insurance products at a 93% higher rate than Pre-Movers not exposed to Updater Communications. So this means that Pre-Movers exposed to Updater Communications are more likely to purchase applicable insurance products. It’s a big tick of approval for the product and gives us a level of confidence that Updater can provide tremendous value to insurance companies and the relocation ecosystem.  The company has even stated that “with over 95% confidence that users in the Pilot Program Cohort exposed to Updater Communications are more likely to purchase applicable insurance products than those not exposed to Updater Communications.” These results far exceeded expectations and are an early indicator that the platform works and helps both Businesses and Movers. We think Updater is making inroads fast. It won’t be long before the dollars start coming in and its network effect starts to turn at full speed. The start-up operates in a niche space and solves a problem that so far no other company can. For that reason we like the story and we think there is real upside potential. We think investors should be jumping on the Updater train and adding this stock to their portfolio. But as with all small caps, there is substantial risk.

 Integral Diagnostics (IDX) – Is a provider of Diagnostic Imaging Services in Australia that provide its patients and Referrers with clinical service and access. IDX has a network of 44 sites (including 12 hospital sites) that offer equipment and technology used to take images and a large team of high quality Radiologists andTechnical Professionals. The company has three brands in three states: Lake Imaging in Victoria, South Coast Radiology and Global Diagnostics.

 IDX generates revenue by providing these high quality Diagnostic Imaging Services to Referrers and patients from its network of 44 sites, including 12 hospital sites. Patients might be eligible to receive partial or full reimbursement for services from the Commonwealth Government, private health insurance and other sources. The company goal is to capitalise on the growing demand for Diagnostic Imaging Services. The demand for Diagnostic Imaging Services in Australia has been growing steadily at around of 5.4% between FY2005 and FY2015. The company has 13 years of year-on-year revenue growth since 2002 and has considerable experience in its senior ranks. The management team is led by CEO John Livingston who, with a small group of Radiologists and Radiographers, founded IDX’s original business, Lake Imaging. The company posted its 1H17 profit results in Feb this year which were OK. Back in November at its AGM the company downgraded guidance and management said 1H earnings were likely to be 10% lower. Underlying NPAT was actually down 6.1% at $7.7m. Shares hit a low of $1.05 before rebounding in March. Much of it was due to regulatory changes. The Government had proposed funding cuts to the sector and a reduction in bulk billing incentives for diagnostic imaging, saving $650m over four years. The cuts to diagnostic imaging limit bulk-billing incentives to concessional patients and those under 16. The government is however prepared to invest $50m to help improve patient access to affordable and safe scans and imaging procedures. So quite a harmful regulatory change. But in March the Government announced that it was delaying the bulk-billing changes for 3 months. Discussions with the diagnostic services are ongoing. There are three brokers that cover the stock – 2 buys and 1 Underweight. Credit Suisse released an update in Feb. The broker said the company’s balance sheet remains healthy despite upgrades to capex. IDX’s recent result was broadly in line with the guidance downgrade it made last November, which is why shares have bounced. Whilst the delay in the Governments MBS freeze may be positive, the full regulatory implications are still unclear. The stock is trading at a 35% discount to its peers such as Capitol Health (CAJ), Sonic Healthcare (SHL) and Primary Health Care (PRY). All in all, there is substantial risk regarding Government funding and bulk billing changes. This stock isn’t for the faint hearted. It’s really a punt on whether the funding cuts go through or not. There are doubts as to whether the $640m in spending reduction will even get through Parliament with Labor, Greens and independents raising concerns. It could be a tough fight for the Government to push these changes through Senate. For those wanting to take a position in the stock, be aware that the downside risk is that the Government changes go through.
Otherwise on the chart the stock looks to have bounced following its March results. It’s probably not enough yet to say an upside break out has occurred. But it’s close. We’d advise investors to wait to see the stock around $1.45 before Buying. At that level, the upside break out is confirmed, triggering a bullish buy indicator.