Significant pull back in market presents opportunities

Monday, July 01 2013

Market valuations are nearly 20% cheaper than two months ago, Political uncertainty hurting market confidence.

Independent Australian investment management company, Dalton Nicol Reid has said that market valuations are nearly 20% cheaper than two months ago thanks to the pullback in the market and the lower currency which at current levels adds around 8% to the profit of the market. This is presenting opportunities in a range of stocks.

The S&P/ASX 200 Accumulation Index was down 4.5% in May and 2.4% in the three months to 31 May 2013, with Australia underperforming global markets because a lower Australian dollar has seen overseas investors withdraw from the market. Mr Nicol said the market uncertainty was being fuelled by the fact that domestic confidence, especially business confidence, was currently low.

Jamie Nicol, Dalton Nicol Reid Chief Investment Officer, said while he expected this market volatility to continue, the underperformance gives investors the opportunity to buy undervalued stocks. And that the looming reporting season was likely to demonstrate that quality investments could still be found across the market.

“We see several factors driving this, including the unprecedented long election period followed by political uncertainty, which is causing considerable damage. This makes decision making difficult given the potential for policy settings to change.

“Coupled with this political uncertainty is the poor competitive position of many Australian companies given the very high A$ (up until recently) and high relative labour and energy costs as we deal with the tail end of the resource boom. The consequences of these two factors are that we expect the pressure on the RBA to lower interest rates to remain.”

“Over the past year we have seen resource companies substantially underperform defensive yielding companies. It’s our view that conditions are shifting and that this will enable some of the leading resource companies to claw back some of this underperformance.”

“The factors driving this include:

  • Relative valuation support for the major resource companies remains strong under a range of commodity price assumptions;
  • Lower currency supports resource earnings;
  • Internal focus by the major resource companies on reducing costs and increasing free cash flow should drive shareholder value over time;
  • While yield remains attractive in bank stocks, international investors have been losing on the currency and can be marginal sellers. By comparison they are not major owners of the domestic resource companies given the opportunity to purchase the same companies in the UK.”

“One other area in the domestic economy that is showing signs of life is the housing market (especially if interest rates are lowered further) and there are a range of companies that can benefit from greater housing activity levels,” Mr Nicol said. “We also continue to support those companies with offshore earnings given the support from the recent low currency.”

Dalton Nicol Reid uses a five-point quality matrix to identify relative quality of listed companies. This includes balance sheet assessment, industry structure, management, earnings strength and ESG (environmental, social and governance). Mr Nicol said there is a growing body of evidence that supports ‘quality’ investing.

“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.”

Dalton Nicol Reid is is an independent Australian investment management company that delivers client-focused, quality investment solutions to institutions, intermediaries and high net worth investors, It invests on behalf of its clients through Separately Managed Accounts (SMAs), Individually Managed Accounts (IMAs), private client accounts and institutional mandates. The manager’s Australian Equities High Conviction portfolio has produced a return of 13.5% p.a. over ten years, against a benchmark of 9.8%. Over three and five years, returns are 12.2% p.a. (benchmark: 8.5%) and 7.2% p.a. (benchmark: 1.8%) respectively.


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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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