Alpha POWER Shares (Aegis) Portfolio

Alpha POWER Shares (Aegis) Portfolio - August 2009

Monthly Stock Returns (including dividends)

Aegis Market Commentary

August was another good month for the Australian share market, with the S&P/ASX 100 Accumulation Index adding to its recent gains and rising by 6.7% for the month. Although the August reporting season saw significant declines in profits across most sectors highly exposed to the weaker economy, the expectation that the worst is probably over buoyed stocks across a number of cyclical sectors. Property (16.0%) was the best performing sector as investors started to form the view that we may be approaching the end of the downward property revaluation cycle. Also, balance sheets across the sector are looking much healthier following the spate of capital raisings in recent months. Financials (ex-Property) was the next best performing sector, with the index rising 12.8%, boosted by a strong performance from the banks. CBA reported its result in August and, although earnings fell as expected due to higher bad debt charges, strong balance sheet and revenue growth demonstrated the resilience of the domestic banks in the current economic environment. Industrials (11.7%) also rose strongly, partly due to the fact that many balance sheets were strengthened by recent capital raisings but also due to a market focus on companies likely to do well in an economic recovery. Again, a number of defensive sectors underperformed the market, with Telecommunications (-3.6%) and Utilities (-3.3%) being the worst performing sectors. Materials (-0.5%) also underperformed, as the sector took a breather following its recent strong performance and the market focused on the reality of lower earnings in the short term due to reductions in commodity prices. Index performances include dividends.

Global equity markets have remained reasonably positive over the past month, although there have been bouts of selling when concerns about the speed of a global recovery take hold. While there seems to be a general consensus that we have now seen the worst of the global financial crisis and economic downturn, the key international economies remain fragile and the road to recovery is likely to take some time.

The August US job loss report showed that job losses continued to decline, with a total of 216,000 jobs lost for the month. This is the lowest monthly job loss figure since August 2008. However, the unemployment rate continued to increase, rising to 9.7%, and is still expected to rise to more than 10%. A sustained recovery in the US housing sector remains crucial to a US economic recovery. While housing starts rose strongly in June, the July data showed that housing starts fell by 1% to an adjusted annual rate of 581,000 units, which is still 37.7% below the July 2008 rate of 933,000 units. Building permits, an indication of future construction activity, dipped 1.8% to a seasonally adjusted annual rate of 560,000 units in July. These figures continue to highlight the extent of the problems in the US economy and while some positive signs are starting to emerge, there is still a long way to go before we can say a recovery is well underway. US 2Q09 GDP was reaffirmed at an annualised rate of -1.0% during the month. The US Institute of Supply Management reported its Manufacturing index was at 52.9 in August, the first time it has been above 50 since January 2008, suggesting an expanding outlook. The Services index improved from 46.4 in July to 48.4 in August, but nevertheless implied ongoing contraction, albeit at a slower rate, for the 11th month in a row.

The Australian economy continues to weather the global economic turmoil very well due to the strength of the domestic financial system and the success of the monetary and fiscal stimulus measures. The 2Q09 GDP data showed that Australia achieved seasonally adjusted growth of 0.6% compared to 1Q09 and 0.6% YoY. The major contributors to the QoQ growth were household consumption, up 0.8%; government expenditure, up 0.8%; and exports, up 1.0%. Offsetting this, imports grew 2.1%, causing a 0.5% reduction to GDP. Private business expenditure rose 1.9%, offset by private dwelling expenditure of -5.5%. Changes in inventories had a net 0.2% impact on GDP. It is worth noting that Treasury estimates YoY GDP would have been -1.3% rather than 0.6% were it not for the economic stimulus measures put in place. It appears that Australia has managed to avoid a technical recession, although it is worth bearing in mind the recent comments by Treasury Secretary Ken Henry who warned that the international economy was “not out of the woods yet” and that if a “second shockwave” were to hit, it would have implications for Australian growth.

In August, the Reserve Bank of Australia (RBA) left its cash rate unchanged at 3.0% and again maintained this rate following the September meeting. The RBA continued to comment that Australian economic conditions have been stronger than expected and said that growth is likely to firm going into 2010. Unless there is a second shockwave to the global economy, the next move in interest rates is now most certainly to be upwards. The strong June quarter domestic GDP will place pressure on the RBA to act sooner rather than later, although if the federal government uses the GDP outcome to start withdrawing some of its stimulus measures, this will relieve some of the pressure on the RBA.

As we noted earlier in this report, reporting season saw significant profit declines by companies highly exposed to the key cyclical sectors of the economy. Sectors particularly impacted were manufacturing, housing and construction related industries, property, mining and resources, banking and wealth management and consumer discretionary stocks. However, there were also some very strong results, particularly from companies in the healthcare sector, with bumper results from CSL and Cochlear, and consumer staples stocks such as Woolworths. Overall, results were broadly in line with expectations and in some instances a little better than expected. Whilst the outlook commentaries tended to indicate that we have probably seen the worst in terms of earnings downgrades, management outlook commentary generally remains cautious, pointing to challenging market conditions. There seems to be an expectation that we will see an earnings recovery emerge over the next 6-12 months, but the exact timing and extent of a recovery remains uncertain. 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. While this means that many of the stocks we hold can be considered defensive in nature, we also have a number of stocks exposed to an economic recovery. It is those stocks that have performed particularly well this month, although, apart from TLS, our defensive stocks have at least maintained ground in a market focused more on cyclical stocks. We will continue to maintain a core exposure to defensive stocks, as they provide stability of earnings and steady dividend growth. Nonetheless, we will also look for potential opportunities to add large-cap cyclical stocks with good recovery potential as opportunities present.

Aegis’ Comments on Portfolio Stock Performance

Main outperformers

QBE Insurance Group – QBE (20.5%). Following a disappointing performance in recent months, it was pleasing to see QBE finally put in a good performance in August. The market reacted well to QBE’s 1H09 result, which we saw as a good result in the current environment. QBE’s 1H09 profit of $1,018M was up 19% on 1H08, although after allowing for non-recurring gains, the adjusted profit of $989M was up 14% on 1H08. The result benefited from strong growth in premium income, resulting from premium rate increases and recent acquisitions, and was also boosted by foreign exchange gains. The strong revenue growth was partly offset by higher general claims costs, global financial crisis related claims and lower investment yields on the group’s substantial fixed interest portfolio. The higher claims costs saw the insurance margin fall to 17.5%, down from 21.8% in 1H08, but this was slightly better than expected. QBE declared an interim dividend of 62cps, up 1cps on 1H08. We see QBE as being well placed to benefit from a rising premium environment over the next few years and its investment portfolio is positioned to take advantage higher interest rates when the current interest rate cycle turns. Earnings will also continue to benefit form QBE’s strategy of making accretive acquisitions. QBE expects premium income to grow by 15% in Australian dollar terms in FY09 and forecasts the insurance margin to be at the higher end of its 16%-18% target range. Based on these expectations, we are forecasting strong earnings growth for QBE in FY09 and retain our favourable view of the stock.
Westfield Group – WDC (15.9%). WDC’s security price performed well through August, with the stock running up ahead of the release of its 1H09 result in late August. WDC reported what we consider to be a quality result for 1H09 amidst extremely difficult conditions for property funds. The market initially reacted positively to the result, with part of the immediate gain probably reflecting relief that the group would not be making another large capital raising. However, the security price has since retreated from its recent highs. WDC reported a 1H09 adjusted operational profit of $989M, up 13% on 1H08. The statutory result was a loss of $708M, dragged down by downward property revaluations of $2.9B, partly offset by non-cash accounting gains on financial instruments. The operational result was driven by strong revenue growth from WDC’s shopping centre portfolio, which continues to withstand the global economic downturn. For the half, comparable shopping centre net operational income rose by 3%, with the portfolio occupancy rate actually increasing slightly to 96.2%. Australia and NZ portfolio metrics are outperforming; the US portfolio is holding up; and the UK has weakened. In Australia, occupancy levels are greater than 99.5%. WDC distributed 47cps for the first half, but announced a change to its distribution policy effective 2010. From the August 2010 distribution, future distributions will be set at 70%-75% of operational earnings. WDC maintained its earnings guidance for FY09 at 94cps-97cps. WDC’s balance sheet metrics are excellent, with plenty of headroom against covenants. Although the decision to cut the distribution pay out is disappointing from an income perspective, we view the move positively as it means that WDC is preserving capital to help fund future growth rather than raise equity through additional dilutionary security issues. Overall, we retain a favourable view of WDC, but note the emphasis now appears to have shifted more towards growth rather than income. We consider this appropriate, given that we now appear to be at the bottom of the property cycle.
WorleyParsons – WOR (12.4%). WOR’s share price continued to perform well through August with the company releasing what we viewed as a solid result in a tough environment. WOR’s FY09 profit of $390.5M was 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. The Minerals & Metals and Power divisions both were flat on the prior year, with Minerals & Metals impacted by weaker margins and a significant deterioration in mining activity. Infrastructure & Environment reported a lower result due to weaker margins and slower growth from projects related to the mining industry. WOR declared a final dividend of 55cps, fully franked, taking the full year dividend to 93cps (90.2% franked), an increase of 9% on the prior year. The company said it expects a modest decrease in earnings in FY10, mainly due to much lower earnings from the Minerals & Metals division and an expected negative impact of a higher Australian dollar. We continue to view WOR favourably and see the slight drop in earnings forecast for FY10 as being a good outcome, given the difficult industry conditions. Given the solid client base and a large portfolio of 'mega' and longterm projects, we are forecasting a return to strong earnings growth in FY11.

Main underperformers

Telstra – TLS (-3.7%). TLS’s share price performed very well in the early part of August and was helped by the release of a reasonably good FY09 profit result in the middle of the month. TLS reported an FY09 NPAT of $4.1B, up a solid 10.3% on FY08 and in line with guidance. Sales revenue grew by 2.9% and earnings before interest and tax (EBIT) growth of 5.3% was just above TLS’s targeted band of 3%-5%. The revenue growth was driven by the key Mobile Services (10%) and Fixed Retail Broadband (15.9%) products, with the old fixed line PSTN revenues falling by 4.9%. Given the difficult economic environment, management gave FY10 guidance of low single-digit growth in revenue and EBIT. TLS declared a final dividend of 14cps (ff), maintaining its full year dividend at 28cps (ff). Importantly, the dividend is largely funded by the $4.4B in free cashflow, with TLS maintaining its guidance of $6B in free cashflow in FY10. On 20 August, following the release of TLS’s profit result, the Australian government’s Future Fund sold 684.4M TLS shares (34% of its holding) at $3.47 per share, a 4.9% discount to the day’s closing price. The shares were sold to a range of institutional investors. The Future Fund retains a 10.9% stake in the company. Since the sell down, TLS’s share has languished at lower levels. We attribute this partly to market indigestion following the sell down. We would hope that once the additional shares have been absorbed into the market, TLS’s share price performance will improve, although the continued market focus on cyclical stocks could limit the extent of any recovery in the share price. Given the high dividend yield, which is well covered by TLS’s strengthening cashflows, we retain our positive view of the company. Nonetheless, we continue to monitor the risks in relation to the National Broadband Network and potential regulatory changes. In this regard, we note that the new CEO, David Thodey, is developing a better working relationship with the government than his predecessor.
Metcash – MTS (0.0%). MTS’s share price finished the month unchanged in the absence of any news from the company. However, since the end of the month, the company has made a couple of important announcements. First, MTS announced that it had reached an agreement for the supply of grocery and liquor products to 45 supermarkets and eight aligned liquor stores that Foodworks will acquire from Coles. The supply agreement is for an initial period of 10 years and MTS expects the new Foodworks stores will add around $250M to its annual sales in the first full year. This is equivalent to around 2.25% of MTS’s sales for FY09. Second, 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. We retain our positive view of MTS and continue to see it as an ideal inclusion in the portfolio, given its attractive, fully franked yield and outlook for steadily rising earnings and dividends.
Tatts Group – TTS (1.2%). The TTS share price performance during August was disappointing, given the company reported a solid FY09 profit result and increased its full year dividend by 5%. TTS reported an adjusted FY09 profit of $280.8M that was up 9% on the prior year, but marginally below our forecast. The robust earnings performance can be attributed to a recovery in the wagering business, a strong Lotteries result and double-digit EBIT growth in Tatts Pokies. Revenue grew by 5%, a good result in a weak environment for consumer spending, and margins improved as the company continued to take costs out of the Pokies business ahead of the licence expiry in 2012. TTS declared an 11cps (ff) final dividend taking full year dividends to 21cps up from 20cps in FY08. We expect further growth in earnings in FY10, but at a slower pace than that in FY09. We do not expect the Lotteries business to experience the strong run of jackpots that it had in FY09, although the Pokies business should continue to do well as costs and capital expenditure are reduced. One of the critical issues for TTS is to find replacement earnings streams for the Victorian Pokies business leading up to the expiry of the licence in 2012. As we have discussed before, there are a number of potential options for TTS, including the Victorian wagering licence and the NSW Lotteries business. In August, TTS announced it would not be bidding for TOTE Tasmania. While we had previously viewed TOTE Tasmania as one of the potential growth options for TTS, we note that the Tasmanian TOTE is a relatively small operation and we continue to see the NSW Lotteries as the main opportunity for TTS to achieve growth by acquisition. TTS has a strong balance sheet, which gives it the financial flexibility to fund any successes it may have in picking up new licences or businesses. At current levels, the stock offers a very attractive dividend yield in excess of 8%. At current prices, we retain our favourable view of TTS.

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.