Reporting season expected to further shift investors to equities from bonds

Monday, March 04 2013

But focus on quality crucial to investment success in 2013

Independent Australian investment management company, Dalton Nicol Reid said the recent strong reporting season should intensify the current shift in asset allocation seen among professional investors.

Chief Investment Officer, Jamie Nicol, said even with recent market volatility, he expects asset allocations to continue to swing away from bonds towards equities. He warned however, that a focus on quality is necessary to distinguish between those equities that have genuine operating upside as the cycle turns, as opposed to a simple short covering rally.

“Given risks now seem to be easing and interest rates are low, we expect flows to be supportive of equities. Additionally, any pullback in the market is likely to be well supported by the amount of money sitting on the sidelines,” Mr Nicol said.

“The last few days we have seen a selloff in growth companies that missed their results expectations and I think this signals we will see a little more dispersion in performance rather than the rising tide lifting all boats that we have enjoyed of late. However, this also delivers opportunity.”

Mr Nicol said relative to bond yields, equities looks attractive when compared with either the PE of the market or dividend yields.

“The market is trading at 13.8 times PE, which looks about average and not particularly cheap on an absolute basis (although not expensive either). However once we compare the market to low interest rates, which look like they are here to stay, the story is very different. In particular, we note that the dividend yields available from companies are in many cases already twice the yield available from bonds and the dividend yield should be growing.”

“Over the last few years investors valued the security of bonds regardless of price. As the risks fade, then the value of holding a bond earning less than half the amount available from equities begins to look questionable,” he said. “Investors should also consider the potential of another bond crisis, like the early 90’s, should inflation spike in the US.”

In terms of the recent reporting season, Mr Nicol said growth companies, which have enjoyed a strong run, are starting to be sold off where the results did not meet expectations.

“In some instances we have seen the global growth pick up yet to come through (Ansell); in others we are seeing a simple miss as the businesses mature (Cochlear); and in others, stock specific disappointment (Breville). Interestingly Healthcare has had a difficult reporting season. This is a reflection of Governments pulling back spending from the sector and the recent strong run.”

Mr Nicol said there are definitely signs of a pick up in housing and to a lesser extent, media and retail. “In some instances, this has triggered a short covering rally. For example, we are reluctant to buy JB Hi Fi, given they continue to face structural threats. Sales of CD’s, DVD’s and games are shrinking as consumers purchase on-line. The main categories that are growing (Ipads and other tablets) offer lower margins.

“We are seeing a range of companies lift earnings including leaders such as the banks and Wesfarmers. This is providing a further kick along for these companies, although in my mind, it really just justifies the rally to date.”

Mr Nicol said good results from CBA and Bendigo highlight the easing funding conditions for banks, which is driving stronger profits.

“Expected profit growth for the major banks has been lifted a couple of percent. Strong capital position increases the likelihood of future buy backs and bad loans are easing as interest rates decline. This increases market confidence regarding FY14. The trends are particularly favourable for the domestic retail banks, hence the strong moves by CBA and WBC.”

Dalton Nicol Reid uses a five-point quality matrix to identify relative quality of listed companies. This includes balance sheet assessment, industry structure, management strength, earnings strength and ESG (environmental, social and governance). Research on quality investing has largely focused on the back testing of various quality screens to determine the impact of quality on returns. On the whole, this research has shown a strong linkage between quality and performance over the medium and long term.

“A quality portfolio will be agnostic to value or growth. Following a quality investment approach allows us to identify companies that are mispriced by overlaying this quality filter with a strong valuation discipline. It also allows us to enhance returns by identifying companies when they are out of favour.”


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About Dalton Nicol Reid

Dalton Nicol Reid is an independent Australian investment management company that delivers client-focused, quality investment solutions to institutions, intermediaries and high net worth investors. The basic foundation of the business is to our clients’ needs first and provide them with an unparalleled level of service, be they institutions or individual investors.

Dalton Nicol Reid has a rigorous investment process proven through various market cycles and our client-oriented Individually Managed Accounts (IMAs) and Separately Managed Accounts (SMAs) solutions are pioneering developments within Australian financial markets.


About Quality Investing

In Dalton Nicol Reid’s view the following reasons help explain why quality companies outperform:

Quality companies generate more capital that can be reinvested to drive sustainable returns over time. This can be achieved via appropriate deployment of capital either internally or via M&A.

  • Companies in structurally superior industries with pricing power can grow above CPI and are more protected against inflation.
  • Higher quality balance sheets help to ride out cycles.
  • The ability to value quality companies is enhanced by the sustainability of earnings. So quality companies will tend to trade at a premium.
  • Quality companies tend to recognise the benefits of good ESG policy. As financial analysts tend to ignore ESG risks in terms of valuing companies and identifying risks, these benefits are often understated.

The concept was first recognized in the 1930s by Benjamin Graham, who classified stocks as either high or low quality. Mr Graham found that the greatest losses resulted not from buying quality at an excessively high price, but from buying low quality at a price that seemed good value.

Another celebrated study was by conducted by University of Chicago Accounting Professor, Joseph Piotroski (2000) who reasoned that because value stocks are by definition often troubled companies, many will not possess the financial resources to recover. Consequently, Piotroski wondered if it was possible to improve the performance of a value stock portfolio by eliminating stocks that were the weakest financially.

Piotroski devised a simple nine-criteria stock-scoring system, called FSCORE, for evaluating a stock’s financial strength that could be determined using data solely from financial statements. His findings were that these strong stocks as a group outperformed a portfolio of all value stocks by 7.5% annually over a 20-year test period. Piotroski also found that weak stocks, scoring two points or fewer, were five times more likely to either go bankrupt or delist due to financial problems.

The Piotroski’s scoring system gave one point if a stock passes each test and zero if it did not. The basis was as follows:

  1. Net Income: Bottom line. Score 1 if last year net income is positive.
  2. Operating Cash Flow: A better earnings gauge. Score 1 if last year cash flow is positive.
  3. Return On Assets: Measures Profitability. Score 1 if last year ROA exceeds prior-year ROA.
  4. Quality of Earnings: Warns of Accounting Tricks. Score 1 if last year operating cash flow exceeds net income.
  5. Long-Term Debt vs. Assets: Is Debt decreasing? Score 1 if the ratio of long-term debt to assets is down from the year-ago value. (If LTD is zero but assets are increasing, score 1 anyway.)
  6. Current Ratio: Measures increasing working capital. Score 1 if CR has increased from the prior year.
  7. Shares Outstanding: A measure of potential dilution. Score 1 if the number of shares outstanding is no greater than the year-ago figure.
  8. Gross Margin: A measure of improving competitive position. Score 1 if full-year GM exceeds the prior-year GM.
  9. Asset Turnover: Measures productivity. Score 1 if the percentage increase in sales exceeds the percentage increase in total assets.


IMPORTANT NOTE: This information has been prepared by DNR AFSL Pty Ltd ABN 39 118 946 400, an Australian Financial Services Licensee, Licence Number 301658. Whilst, Dalton Nicol Reid has used its best endeavours to ensure the information within this document is accurate it cannot be relied upon in any way and recipients must make their own enquiries concerning the accuracy of the information within. This document is not intended to provide you with personal advice and in providing this information, Dalton Nicol Reid has not taken into account your particular investment objectives, financial situation or needs. You should assess whether this information is appropriate for your particular needs, either by yourself or with your adviser. Dalton Nicol Reid expressly disclaims any responsibility or liability to anyone who acts or relies upon anything contained in, or omitted from, this document. Past performance is not indicative of future performance. Total returns shown are based on Dalton Nicol Reid’s model portfolio and have been calculated before taking Dalton Nicol Reid’s fees into account. No allowance has been made for taxation.
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