ALPHA Structured Investments
Alpha POWER Shares (Aegis) Portfolio - September 2009

Alpha POWER Shares (Aegis) Portfolio - September 2009

Monthly Stock Returns (including dividends)

AEGIS Montly 0909

Aegis Market Commentary

The Australian share market continued to rally through September, with the S&P/ASX 100 Accumulation Index rising by 6.4% for the month, or 5.3% from 31 August 2009 to 24 September 2009, the option reset date. Consumer Discretionary (10.6%) was the best performing sector, with the market anticipating that increasing consumer confidence would translate into stronger retail spending and increased advertising revenue for media companies. Information Technology (10.5%) was the next best performing sector, with Computershare (CPU), one of the main components of this sector, rising strongly. CPU is expected to benefit from a recovery in investment markets during FY10, with stronger transactional revenues across its business lines. Telecommunications (0.3%) was the worst performing sector, as the market remains uncertain about the outlook for Telstra in the wake of the federal government’s move to split the company. Energy (1.5%) and Materials (2.6%) also underperformed the market, as oil, copper and other commodity prices consolidated after a strong rise through July.

Global equity markets have continued to rise over the past month, although concern about the state of the US economy and whether the recovery is as strong as had been expected saw some selling towards the end of September. We repeat our comments of last month that although we have seen the worst of the global financial crisis and economic downturn, the key international economies remain fragile, particularly the US, and the road to recovery is likely to take some time.

US jobs data for September revealed that 263,000 jobs were lost for the month, up from 216,000 in August and higher than expected. The largest job losses were in construction, manufacturing, retail trade and government. The figures for July and August were also revised upwards. The unemployment rate at 9.8% continued to creep towards the 10% level. On a more positive note, however, August housing starts rose 1.5% to an annual rate of 598,000 following a dip in July. Building permits, an indication of future construction activity, rose 2.7% to an annual rate of 579,000 units. The US Institute of Supply Management reported its Manufacturing index was at 52.6 in September, above 50 for the second consecutive month. This was down slightly from 52.9 in August, but nonetheless continues to suggest an expansion in manufacturing activity. The Services index improved from 48.4 in August to 50.9 in September, indicating growth in the non-manufacturing sector after 11 consecutive months of contraction.

In its most recent World Economic Outlook Projections, the International Monetary Fund (IMF) said that the global economy appears to be expanding again, but noted that the pace of recovery remains slow. World output is now expected to decline by 1.1% in 2009, a 0.3% improvement over the previous forecast. Its 2010 forecast has improved to 3.1%. For the US, the IMF has slightly downgraded its 2009 forecast by 0.1% to a decline of 3.4%, but raised its 2010 forecast by 0.7% to growth of 1.5%.

The Australian economy continues to perform well in the face of the weak global economy. In September, the seasonally adjusted unemployment rate fell from 5.8% to a lower than expected 5.7%. This is well short of the 8.5% peak previously forecast by Treasury. The lower than expected jobless numbers are also reflected in strong consumer confidence numbers, with the Westpac-Melbourne Institute Consumer Sentiment Index up 5.2% in September to 119.3 points. Seasonally adjusted retail sales rose by 0.9% in August, with department store sales showing strong growth at 2.4%. The underlying strength of the Australian economy was behind the Reserve Bank of Australia (RBA)’s move to increase interest rates in October.

In September, the RBA left its cash rate unchanged at 3.0%, but increased this rate by 25 basis points to 3.25% following its October board meeting. In its monetary policy commentary, the RBA noted that global economic growth is resuming and with economic policy settings likely to remain expansionary for some time, the economic recovery is likely to continue into 2010. The RBA also said that the basis for the low interest rate setting established when there were considerable downside risks to the economy has now passed and “that it is now prudent to begin gradually lessening the stimulus provided by monetary policy”. Given how well the Australian economy has performed, we expect the RBA to increase its cash rate by at least another 25 basis points before the end of calendar 2009, unless there are further unexpected shocks to the economy. We expect this to be followed up by further rate increases early in 2010. The extent to which the RBA lifts rates early in the new year will depend on the continued strength of the Australian economy, the impact that its tightening policy is having on key segments of the economy and the extent to which the federal government starts withdrawing some of its stimulus measures.

It is clear that the worst is now over for the global economy and the outlook is for gradual improvement over the next year. The Australian economy in particular remains in very good shape. This sets the scene for growth in company earnings, with positive implications for the share market. However, following its strong rally over the past quarter, with the S&P/ASX 100 Accumulation Index up by 21.6%, we remain cautious about the short-term outlook. Within the Alpha POWER Shares (Aegis) portfolio, we maintain a bias towards larger, well-managed companies with sound financial positions, strong businesses and stable but growing revenues. This strategy has served us well over the past month and, with the exception of Telstra, all stocks recorded positive performances. We believe the portfolio is well positioned to benefit from further gains in the market. If the market experiences a period of consolidation after recent gains, then we believe the defensive nature of many of the stocks in the portfolio will provide a degree of protection.

Aegis’ Comments on Portfolio Stock Performance

Main outperformers

  • Commonwealth Bank – CBA (8.7%). CBA’s strong performance in September mirrors the performance of the overall financial sector, which rose by 9.9% for the month. The strong performance by the banks reflects increasing recognition by the market that, despite current high bad debt levels, the underlying businesses remain strong and that the sector has increased its dominance, thanks to the global financial crisis. In August, CBAreported FY09 cash earnings of $4.4B, down 7% on FY08. The result was in line with expectations and was significantly impacted by a three-fold increase in bad debts to $3.05B. CBA experienced strong growth in operating income (up 14%), with underlying operating costs tightly managed, driving down the cost-to-income ratio to 43%. Margins increased 8 basis points to 2.10%. Retail Banking was the best performing business, with a profit increase of 10%, while Institutional and Wealth Management suffered large declines in earnings. CBA declared a final dividend of 115cps (ff), taking the full-year FY09 dividends to 228cps, down 14% YoY. This was a good result, given the difficult environment, broadly in line with our expectations and previous CBA commentary. CBA has a very strong franchise and, once the bad debt cycle works its way through, we expect to see earnings recover strongly. Additionally, we expect CBA to maintain its tight focus on costs such that revenue growth will continue to outstrip cost growth. CBA is also well positioned in the Wealth Management space and this business will experience a strong rebound with the recovery in markets. Capital remains strong, with Tier one capital of 8.07%, well above the bank’s internal target minimum of 7%. While CBA’s Tier one capital is below that of ANZ and NAB, we see no reason for CBA to increase its capital to levels that appear to us to be excessive. We maintain our positive view of CBA.

  • CSL – CSL (7%). Considering its defensive nature, CSL has done well in a market focused on cyclicals and potential recovery stocks. In August, CSL reported an adjusted FY09 NPAT of $1.05B, up 50% on FY08. The result was driven by strong sales growth in the key blood products business, CSL Behring, but also benefited from favourable exchange rate movements. CSL Behring also reported a solid improvement in margins due to ongoing efficiency gains and a better product mix. Flu sales and GARDASIL royalties were a little disappointing, but the coming northern hemisphere winter should yield a much better result for flu vaccine sales. The final dividend of 40cps, unfranked, was up 74% on FY08. This was an excellent result from CSL and, although it did benefit from currency movements, in constant currency terms, NPAT was up by a very strong 23%. The result demonstrates the underlying strength of CSL’s core blood products business and the company is guiding for a further 14%-24% rise in earnings in FY10 on a constant currency basis. However, if the Australian dollar remains at its current highs, then reported AUD earnings will not be as strong. Despite the potential currency headwinds, the fundamental outlook for CSL remains strong. Plasma market fundamentals remain favourable. Increasing take-up of CSL's higher-margin liquid IVIG product will deliver further yield and margin gains. We like CSL's recession-resistant business, which has robust organic growth prospects. We retain our favourable view of CSL.

  • Metcash – MTS (6.5%). MTS is another defensive stock that has performed well this month, making up for some of its underperformance in August. In our August report, we noted that, in early September, MTS announced that it had reached an agreement for the supply of grocery and liquor products to 45 supermarkets and 8 aligned liquor stores that Foodworks will acquire from Coles. The 10-year supply agreement will add around $250M to its annual sales in the first full year, equivalent to around 2.25% of MTS’s sales for FY09. At the company’s AGM, management indicated that sales remained strong through the first quarter of FY10 and reaffirmed guidance of 7%-10% growth in normalised earnings per share for FY10. Also in September, MTS announced that its liquor division, Australian Liquor Marketers (ALM), will cease supplying Woolworths (WOW) subsidiary ALH Group’s liquor requirements in Queensland when its existing supply contract ends on 30 June 2010. The cessation of this supply contract represents a projected sales loss in FY11 of around $420M and an associated impact on MTS's EPS of just 0.77cps. Overall, we retain our positive view of MTS.

Main underperformers

  • Telstra – TLS (-0.9%). TLS’s share price continues to be impacted by uncertainty following the federal government’s shift in strategy on the National Broadband Network (NBN) and regulatory approach to TLS. In September, the government effectively backed TLS into a corner by announcing it would legislate to request TLS to structurally separate its wholesale business voluntarily or face enforced functional separation. The government also said TLS will be prevented from acquiring wireless spectrum while it remains vertically integrated, owns a cable network and maintains its interest in Foxtel. The legislation also outlines regulatory changes to increase the powers of the ACCC over access arrangements and reduce the level of red tape in disputes. We believe TLS is now presented with two real options: 1) the divestment of its wholesale and access business, including related fixed line infrastructure or 2) the migration of traffic from its copper network to the proposed NBN network. Clearly, the government is trying to force TLS to collaborate and we believe the best option is for the company to attempt to negotiate a solution that meets the government’s objectives while also maximising value for its shareholders. One of the critical issues that would need to be resolved would be the pricing for TLS’s wholesale network and fixed line infrastructure. We continue to see value in TLS despite the uncertainty surrounding the NBN and regulatory regime. We expect TLS will be able to maintain its strong cashflow generation over the medium term, which helps to support the attractive dividend payments. We believe further clarity on the regulatory outlook for TLS will be a key catalyst for a re-rating of the stock. At current prices, we see limited downside risk.
  • CFS Retail Property Trust – CFX (2.1%). CFX’s security price has performed very well over the past three months, particularly given the market focus on cyclical stocks. So, its performance through September reflects a consolidation after some strong gains. In August, CFX reported an adjusted FY09 profit of $268M, up 3% on FY08. The resultbenefited from a rise in net property income of 6.6%. On a like-for-like basis, net propertyincome increased 4.7%. CFX's centres experienced retail sales growth of 0.7% to $6.1B while occupancy levels in FY09 improved 10 basis points to 99.9%. The reported result was a statutory loss of $367M, but this included property revaluation write-downs of $549M and other non-cash items totalling $92M. The full year distribution was 12.5cps, up from 12cps in FY08, and the fund manager indicated the FY10 distribution would also be around 12.5cps. This was another quality result from CFX in a difficult environment. CFX retains a quality property portfolio that has performed well due to the strength and mix of its underlying properties. We remain comfortable with CFX as a core portfolio stock.
  • WorleyParsons – WOR (2.2%). WOR has been one of the better performing stocks in the portfolio over the past three months, so its performance in September represents a consolidation of these gains. As noted earlier in our report, the oil price experienced a period of consolidation through September, so this helps to explain WOR’s performance for the month. As we noted in our August report, WOR reported a strong FY09 profit result of $390.5M, up 14% on FY08 and in line with our forecast. The result was driven by strong revenue growth (26%), particularly from WOR’s core Hydrocarbons business and positive contributions from foreign exchange movements. In September, WOR was awarded a contract by United States Steel Corporation to form a Capital Projects Alliance to support four integrated steel works and its US tube-making operations. The contract is expected to generate revenues in excess of US$50M. The agreement will commence in November 2009 and have a nominal three-year term. Following the end of September, WOR announced it has been appointed to conduct a prefeasibility study for Flinders' Pilbara Iron Ore Project in Western Australia. The site investigation is expected to commence shortly with completion forecast for mid-2010. The bankable feasibility study is scheduled to commence in 3Q10. We retain our positive view of WOR.
IMPORTANT NOTE:
Aegis Investment Partners Pty Ltd (ABN 98 096 109 125, AFSL 226 957) (“Aegis”) is the stock selector for the Alpha Model Portfolio – Aegis. The information contained in this document is prepared by Aegis for use solely by professional investment advisers and is not intended to be provided to retail clients. In preparing this information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors should obtain individual financial advice from their investment advisor to determine whether information contained in this document is appropriate to their investment objectives, financial situation or particular needs before acting on that information. Prior to deciding whether to acquire, hold, or sell the Alpha Model Portfolio - Aegis, you should obtain and consider the Alpha Customised Portfolio Service Product Disclosure Statement dated 19 December 2006 (now closed for new investments but still actively being managed for existing investors) and the Alpha Customised Portfolio Service Product Disclosure Statement dated 3 March 2008 (to be read in conjunction with individual financial advice), available on request from Alpha Structured Investments (1300 769 694 or www.alpha-invest.com.au). While all information is provided by Aegis in good faith, Aegis makes no warranties as to its accuracy, reliability, completeness or whether it is free from error or omission. Subject to statutory limitations, Aegis, together with its directors, officers, employees and related body corporates, do not accept any responsibility or liability arising from decisions made relying upon information contained within this document. This document is only to be distributed to Australian residents. All intellectual property relating to this document vests with Aegis unless otherwise expressly agreed.