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

Alpha POWER Shares (Aegis) Portfolio - July 2009

Monthly Stock Returns (including dividends)

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Aegis Market Commentary

In July, the Australian share market recorded strong gains in line with a strong rebound in share markets in the US and Europe, with the S&P/ASX 100 Accumulation Index up 7.2% for the month. With further signs that the deterioration in the global economic outlook is starting to slow, there was a strong market focus on cyclical stocks, with the Industrials sector (+10%) recording the strongest gain. Other cyclical sectors to register strong gains included Materials (+9.5%) and Consumer Discretionary (+9.4%). Financials, excluding property, (+8.5%) also recorded strong gains, with the banking sector performing particularly well. The strong focus on cyclicals saw defensive stocks underperform the broader market, with Healthcare (-3.3%) being the worst performer. Property (+2.4%) also underperformed, as did the defensive sector of Telecommunications (+4.1%). Energy (+4.1%) underperformed the overall market, with the oil price dropping through the early part of July, before staging a recovery in late July and early August.

There is a general consensus that positive economic growth, albeit muted, will resume at a global level in 2010, assisted in part by a continuing growth profile in the major Asian economies of China and India, combined with modest recoveries in western economies. The OECD forecasts a lift in global GDP of 2.3% in 2010 following a decline of 2.2% in 2009, while the World Bank is expecting a 2.9% decline in activity this year to be followed by a 2.0% rise in 2010 and a 3.2% lift in global GDP in 2011. The IMF forecasts a global GDP decline of 1.3% this year, followed by a modest recovery of 2.4% in 2010, an improvement nevertheless from its April forecast of 1.9%.

The US economy remains fragile, although there are some positive signs with new housing starts rising unexpectedly in June to an annual rate of 582,000, the highest level since November 2008. Building permits rose by 8.7% in June to an annual rate of 563,000, the highest level for the year. US house price declines continued to abate in May, with the S&P/Case Schiller Home Price Indices showing that although still negative, the annual rate of decline of the 10-City and 20-City composites improved for the fourth consecutive month. The 10-City and 20-City Composites declined 16.8% and 17.1%, respectively, in May compared to those in the same month last year. This represents improvements over April’s data, which showed annual declines of 18.0% and 18.1%, respectively. In June, US consumer spending increased for the second month in a row, with spending rising by 0.4% in June after a revised increase of 0.1% in May. However, with wages and salaries falling by 0.4% in June compared to those in May and the unemployment rate expected to climb above 10%, the recovery in consumer spending, which is crucial to a US economic turnaround, is likely to remain fragile.

In July, the Reserve Bank of Australia (RBA) left its cash rate unchanged at 3.0%, with the RBA noting that that the global economy is stabilising after a sharp contraction in demand during the December and March quarters. It said that downside risks to the outlook have diminished, with conditions in global financial markets improving this year and action to strengthen balance sheets of key financial institutions under way. The cash rate was maintained at 3.0% following the August meeting, with the central bank noting that the risk a severe contraction in the Australian economy has abated with conditions stronger that had been previously expected.

In Australia, we have commenced the reporting season for the period to 30 June 2009 and we expect to see a number of weak results, particularly from companies in cyclical industries and those exposed to consumer discretionary spending. While we acknowledge there are early signs that the rate of economic deterioration may be slowing, we are concerned that the strong market rally of the past few months may not last if the earnings outlook does not start to show signs of improving. In this regard, the outlook commentaries during reporting season will be critical and valuations may be tested if company outlook commentaries do not meet expectations and forward earnings estimates are lowered further. 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 means that many of the stocks we hold can be considered defensive in nature, that is, stocks such as Woolworths, Tatts Group, CSL, Metcash, Coca-Cola Amatil and CFS Retail Property Trust. We consider that these stocks provide a stable core to the portfolio with steady dividend streams; however, many of them have not performed as well as the overall market over the past month, given the market’s focus on cyclicals. Nonetheless, we do have some exposure to an economic recovery with our holdings in the banks, WorleyParsons and QBE Insurance. Following the recent market rally, we will be closely watching company results through the reporting season and will look for potential opportunities to increase exposure to oversold, high-quality and large-cap cyclical companies.

Aegis’ Comments on Portfolio Stock Performance

Main outperformers

  • Commonwealth Bank – CBA (+9.7%). CBA was again the best performing stock in the portfolio in July. There was no major news from CBA through the month, although the group announced that its wealth management division had grown its funds under administration by 6.9% in the June 2009 quarter to $175B. Net flows for 4Q09 were $4.385B. The wholesale funds business saw net inflows of $3.263B, with balances increasing 9.8% to $45.092B at 30 June 2009. CBA’s Life and General Insurance businesses benefited from a 3.7% increase in in-force premiums over 4Q09 to $1.56B. The increase in funds under administration in part reflects an increase in asset values as a result of the improvement in equity markets as well as the positive funds inflow. If equity market conditions continue to improve, we expect CBA’s wealth management division to make an increasing contribution to its overall result. We remain comfortable with CBA. The group has a strong banking and wealth management franchise and it continues to benefit from strong volume and revenue growth in both lending and deposits. Despite higher bad debt levels, we expect CBA's underlying business to continue to grow, underpinned by its strong franchise, solid business momentum and the benefits of the BankWest acquisition.
  • WorleyParsons – WOR (+8.4%). WOR continued to perform well in July and has been one of the most consistently performing stocks in the portfolio over the past few months. WOR’s solid performance mirrors the strong rise in the oil price over the past few months, although as we noted earlier in our report, the oil price fell through early July before recovering later in the month. There was only one new contract announcement relating to the company in July, with Murchison Metals announcing the appointment of WorleyParsons as Project Management Study Contractor to the Oakajee Port and Rail Project in Western Australia. Murchison said WorleyParsons would play a critical role in completing the project Bankable Feasibility Study and in the design and engineering of both the port and rail components. Feasibility studies for both the Port and Rail Project and the Jack Hills expansion are on track for completion in 2010. We maintain our favourable view of WOR, given its strong client base and ability to continue winning new work. We note that the company has recently won a number of 'mega' contracts, which we expect will support earnings over the medium term.
  • Coca-Cola Amatil – CCL (+8.4%). CCL has performed well since it was placed in the portfolio at the end of June 2009. There was no major news from the company during July; however, as we noted in our June 2009 quarterly review, CCL provided a positive trading update at its AGM in May. CCL indicated that all major regions had strong revenue and volume growth year to date and that it expected to achieve high single-digit growth in earnings before interest and tax for the six months to 30 June 2009. We expect CCL to deliver earnings and dividend growth in FY09 and FY10, given its strong brands, excellent distribution platform and diversification moves. We note that there has been some recent press commentary on NSW government plans to ban bottled water from government departments. Bottled water is only a small portion of CCL’s overall revenue and if such bans are successfully implemented, they are unlikely to have a material impact on CCL’s earnings. Given its relative earnings stability, we expect CCL’s shares to continue performing well regardless of the overall market outlook.

Main underperformers

  • CSL – CSL (-5%). CSL’s share price underperformed the market in the absence of any major news from the company during July. We attribute the underperformance to the strong market focus on cyclical stocks through the month at the expense of defensives. CSL is scheduled to release its FY09 result on 19 August and we are expecting a strong result from the company, given the strong plasma revenue growth posted in recent results by its competitors, Baxter and Grifols. As CSL's products are non-discretionary in nature, we do not expect demand to have suffered from the global economic downturn. However, there may have been some downward pressure on the pricing of some parts of the plasma range in certain countries from governments seeking to offset stimulatory spending largesse with savings on healthcare spending. FY09 will have been an exceptional year for CSL's flu business, given the large one-off orders placed by the US and Australian governments in May-09 for swine flu vaccine. We are looking for CSL to deliver its first $1B adjusted net profit in FY09, with earnings per share up 35% on FY08. Despite the lack of share price performance during July, we continue to view CSL favourably, given the attractive industry fundamentals and the company’s strong growth prospects.
  • Tatts Group – TTS (-3.9%). TTS was another portfolio stock to underperform in July as a result of the market focus on cyclical stocks. The company is due to report its FY09 result in August and we are forecasting solid earnings growth, with net profit up by around 10.5% on FY08 and a full year dividend of 21 cents per share, up from 20 cents per share in FY08. We expect TTS’ wagering division to deliver a solid performance against a weak comparable period and the lotteries division should also post a solid result, albeit below that of last year due to the abnormally long run of jackpots posted in the prior year. The pokies division should see margins improve further as costs continue to be taken out of the business, whilst revenue is expected to have proven resilient to the slowing economic environment. On the regulatory front, with the finalisation of the Victorian government’s decision to remove the pokies duopoly, TTS has limited regulatory risk going forward. In our view, the market has priced in the loss of earnings from this division, with no material licenses due for renewal over the coming year. As we have previously commented, there are a number opportunities for TTS to start to fill the earnings gap left by the loss of the pokies licence. We retain our favourable view of TTS.
  • QBE Insurance Group – QBE (-2%). QBE’s share price again disappointed in July, despite its relatively solid earnings outlook. During July, ratings agency Standard & Poor’s (S&P) raised its credit rating on QBE to ‘A’, from ‘A-’, and reaffirmed its rating on QBE’s core operating entities at ‘A+’. S&P said the upgrade to the holding company rating reflected its view that “QBE’s solid track record of operating cash flows sourced from welldiversified business and geographic streams will likely support QBE Group’s ability to service holding company obligations”. With relation to the stable outlook, S&P said this “reflects our expectation that QBE Group’s diverse business platform should continue to provide strong earnings stability, with capacity to endure some cyclicality in underwriting performance. We also expect that QBE Group will maintain a solid balance-sheet structure even as it continues to pursue acquisition-based growth”. During July, QBE reached agreement to acquire Elders Insurance, which underwrites insurance products for distribution through the Elders network. It also acquired a 75% stake in the Elders insurance agency business and will subscribe for a 12% stake in Elders Limited. The total consideration for the transaction is $315M. Net profit after tax from the Elders Insurance and Elders Insurance Agency businesses is anticipated to be around $30M in the 2010 calendar year. We view the Elders’ acquisition positively, although it is a relatively small acquisition in the context of QBE’s overall business. The Elders business generates gross written premium of around $500M against our expectations of around $17B in gross written premium for QBE in FY10. Nonetheless, QBE has a strong track record of successfully integrating acquired businesses into its group business structure and importantly, generating increasing insurance underwriting profits. We expect the Elders transaction will be no different. We retain our favourable view of QBE and expect the group will continue to grow its earnings over time via selective, value-accretive acquisitions.
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.