Year Ending 31/12/18 Performance: +12.50% (+16.22% annualised) - Part 2/2
This is part 2 of my YE 31/12/2018 report for my portfolio performance. Please see here for part 1.
Quick Introduction (again):
Part 2 for my calendar year 2018 report explores the thoughts that I have for the outlook in calendar year 2019 (i.e. 01/01/19 to 31/12/19). I will also touch on stocks that I am watching closely and hoping to add into my portfolio at the right price. After all, it was Warren Buffet (founder of Berkshire Hathaway), who states:
"Price is what you pay and value is what you get."
Market outlook for 2019:
As I mentioned in my YE 31/12/2017 report before, making macro predictions is incredibly tough. I do not claim to have a crystal ball that tells me exactly what will happen in 12 months time. However, I still think it is a helpful exercise, to logically think through probabilistically what may or may not happen in 2019. After all, CEOs in ASX companies have to give their outlook statements for the next financial year. I am beginning to understand just how difficult their job is.
In fact, I remember John Tuld, the CEO of a hypothetical investment bank on the brink of the GFC in November 2007 in the film, Margin Call (2011) states:
"I'm here for one reason and one reason alone. I'm here to guess what the music might do a week, a month, a year from now. That's it. Nothing more."
For context, a lot of these macro predictions can be used to give top-down direction in my stock picking in the ASX, but fundamentally I remain a bottom up stock picker.
So here are 7 macro predictions I am currently thinking through for 2019 which may happen:
1. USD to fall relative to AUD, perhaps back towards USD/AUD of 0.75
The strengthening USD from 2018 has had a good run, but in my view, will likely run out of steam in 2019. It is one of the largest asset classes in the world. There are likely to be some headwinds for the US economy, as the federal tax cuts to 21% drove earnings growth for companies with US operations for much of 2018.
If the Fed does not raise rates as much as the market expects, it is possible that there could be lower demand for USD to buy fixed income products (denominated in USD) that guarantee a safe yield. The USD has already gone through a strong bull run, and it is likely to unwind in 2019 in my view.
As such, ASX companies reporting in USD could be hurt in the short-term, meaning any companies that generally rely on exporting to overseas as part of their core operations could be hurt.
2. Crypto asset prices to continue their fall, particularly Bitcoin
Crypto currencies to me, just do not look like they have any tangible value at all (if anybody can educate me on this, I am open to listening but I remain sceptical). For example with Bitcoin, that is an asset that to me looks like it's anybody's best guess on how many jellybeans are in the jar. Maybe you're better off shouting your own estimate, rather than hearing others' estimates then giving your own (which is probably biased by others' estimates).
The problem is that there generally continues to be a huge influx of speculators in this asset class. What will need to change, is regulation that can improve transparency and maybe then can institutional users like fund managers or investment banks can then adopt it more readily. In 2018, we saw Goldman Sachs, bail on the idea of a Bitcoin trading desk, and JP Morgan's CEO, Jamie Dimon, bashing Bitcoin on the press, as examples.
The irony though, is that Bitcoin, and many other crypto currencies from my understanding, are designed to remove the middleman (i.e. the financial institution) in a transaction. So the very need to gain popularity for this asset class through transparency, cannot be done as it seeks to remove the very thing that gives it credibility...
Alas though, as more and more regulation inevitably comes into this asset class for the sake of 'protection from exuberant capitalism' by the governments, the prices will likely unwind downwards, as the speculators get flushed out in 2019. I am not saying that this asset class will die and never exist again. I am simply saying that much of the speculators that made up the asset classes in trades, will sell and leave, at least in the short-term.
3. Benign growth for ASX, but still think we can be up (although marginally)
Since March 2009, this bull market (i.e. the ASX) has performed well. To me, valuation metrics like P/E (i.e. ~16.7x in Oct 2018, but certainly lower since) have turned fairer following the recent correction of late 2018, although it still hovers at the historical average (when considering the last ~38 years).
It is possible that the 1st half of 2019 could be tough. I think a material trigger could be the release of the Final Report from Commissioner Hayne from the Royal Commission in February 2018. Yet, I still stand by my argument that the market has already overreacted to the 'potential' damage by the report, and that is effectively already priced into the banking sector generally.
The big 4 banks make up about 25% of the ASX index, and thus will have a meaningful impact on the direction of the ASX for 2019. Balance sheets for companies generally do appear stronger than 2007 from the stocks that I have researched, and extrapolating that, this should allow for those companies' valuations to be justified in 2019 (without need for any violent selloffs fundamentally).
Possibly a catalyst will be needed in the 2nd half of 2019, but once a rally gets underway, it is possible the ASX can finish higher than 2018. Perhaps 5800-6000 points by the end of 2019.
4. US and China hopefully to reach truce
Almost 1 year ago, I remember the market was looking for things to worry about, as it always does... I could remember the fears of US going to war with North Korea, and that we would have a World War 3 in 2017. This clearly did not happen in 2018 (and nobody talks about this anymore). Although not exactly the same as the US and China trade war, there does appear to be some similarities to me.
To me, much like the US vs North Korea fear, I feel that the trade war has also been overreacted to by the market. As such, the likely outcome in my view, is that a truce will play out between US and China.
A really good slide I saw from Ellerston Capital, summarises the possible outcomes:
Based on the points I have made, it would seem like a "Negotiated Outcome" is the probable outcome in my view. Currently, the US has a 90 day truce with China (following a G20 meeting in Nov 2018), before hiking tariffs on $200b worth of goods from the current 10% to possibly 25%. This is keeping the markets up at night.
For example, I asked Toyota Motor Corp's Financial Controller from Japan recently about what kept him up at night for Toyota. It turned out that tariffs were the number 1 fear, and he noted that a potential $267b additional goods could have a tariff impact in 2019, if Trump continues through with his push. There's no doubt this would have a negative impact to earnings, especially for car manufacturers who ship auto parts/vehicles from China into US.
Any evidence that signals a de-escalation of the trade war, should then be materially favourable to stock markets across the world, including the ASX. It would be ideal for a resolution before the 90 days are up.
However, do note that China is a huge addressable market for a lot of large US companies. For example, China can stop Starbucks from operating coffee shops, or Apple from selling iPhones in China.
Thus, there are clearly ways for China to retaliate and US should be aware of that. China does have other policy levers, like cutting reserve requirements for banks, or quantitative easing through purchase of treasury bonds, or cutting the RMB relative to USD, to offset some of the impacts from any trade war escalation.
5. Hold for interest rates in the AU by the RBA for 2019
I think this is similar to market consensus. It is possible that the language by the RBA for economic outlook is likely to deteriorate (albeit not dramatically), as GDP continues to slow down. Since August 2016 when the RBA began holding the cash rate at 1.5%, it would not surprise me to see the RBA continue to hold for the calendar 2019.
If anything, there is possibly a chance that the RBA could decrease the cash rate during the year, as local economic data begins to slip, and more firepower may be needed in the economy, although I still think that is unlikely to happen. The language by Dr Lowe from the RBA minutes of December 2018 (see here), still suggest somewhat of a rate hiking bias, although I still think the RBA could be wrong on this one, and that they will likely continue to hold, as wage inflation remains stagnant for 2019.
It is also possible that before cutting the cash rate (if that were to eventuate), the RBA could turn to easing foreign investment in Australia, or APRA could ease capital requirements for banks (which we already somewhat saw with APRA removing the 30% cap on interest only loans as % of total loans issued by the banks).
6. One or two interest rate hikes by the FED in US
I confess that originally, I was leaning towards the fact that the FED needed more interest rate hikes in 2019. However, upon reflection, I personally think it is more than likely that there will be less rate hikes than the market and FED anticipate.
Trump is beginning to cause anxiety towards the FED, as he questions the actions of the Chair, Jerome Powell. However, this is not a big deal since the FED is technically independent from the US government.
The FED has an estimated 2-3 rate hikes for 2019. However, if subscribing to the idea that the US economy is slowly running out of steam, then less interest rate hikes will be in order.
A few months ago I noted that the FED could be far off from the neutral interest rate (which I calculated to be ~5%, when the FED rate is only 2.5%). However, even if the rate is far off from the desired neutral rate (i.e. equilibrium rate), the FED may still halt on their hikes in 2019 to prevent any undesired turmoil as borrowers try to keep pace with the inevitable rise in the cost of borrowing.
From the December 2018 outlook statement in the FED minutes (see here), the outlook for 2019 was not as dovish as the market had hoped. I tend to subscribe to market consensus on that view. With the FED rhetoric toning down, it is likely that the interest rate hikes will have to slow, and may have to be slower than the FED anticipates.
Of course, I recall that Peter Lynch (Fidelity fund manager from 1977 to 1990) once jokingly said:
"If anybody guessed interest rates 3 times, they would be a billionaire."
I certainly am no billionaire. Make of that what you will.
7. Australian property cycle to fall, with prices down 5-10%
The market does look like it is overreacting to the property prices going downwards in Australia, particularly on the East Coast. People have done very well in property following the early 1990s recession, which Paul Keating (former PM) described as "one we had to have".
In saying that, it is very possible that the property cycle could turn positive following the Final Report from the Royal Commission. Listening to CEO commentary from REA Group and Domain Holdings in their AGM presentations for 2018, they are suggesting a possible rally in property prices in the lead up the Federal election in May 2019. This is because of fears that negative gearing laws may change (for new investors wanting to buy existing properties), and to lock in the tax benefits for investment properties, it could mean that property demand can rise in the lead up.
REA's CEO pointed to a historical example in 2017, where VIC was about to introduce increased stamp duty on new home purchases, and in the lead up to the effect of the legislation change on 1 July 2017, property prices in VIC rallied upwards as home owners locked in for a cheaper stamp duty in advance.
However, the rest of the 2019 property outlook continues to remain negative. The economy is facing tightened lending standards from banks, full employment, and stagnant wage growth. Just from the trading updates in several retailers, consumer spending leading up to Christmas 2018 is already suggestive of being lower than previous years.
Kathmandu just came out with their ASX announcement today, citing a disappointing retail performance, cutting profit guidance for FY19. Although this could be a company-specific issue, my discussions with several retailers in Macquarie Shopping Centre, and many staff complaining about some of the lofty sales targets being set, like Kidstuff and H&M, seem to suggest by observation at least, that the usually promising Boxing Day sales in 2018, would not deliver as much as the previous year, which could hurt sales for many retailers in the form of downgraded profit guidances in lead up to the February 2019 reporting season. I won't be surprised to see more of these coming soon.
Weakened consumer spending, would also suggest that fewer items are needed for new houses, meaning that it is possible there could be fewer houses if this benign retail environment momentum continues which I think it will, for the rest of 2019.
In summary, what I am suggesting is that the falling property market can spell the signal for falling spending, first on high ticket items (like cars and furniture), to eventually your cheaper discretionary goods like fashion, until all that is left is spending on consumer staples like groceries. That remains to be seen, though I note that new car sales have been down 7% yoy from Nov 2018. It would be interesting for example, to see if Nick Scali cites any negativity in their 1H19 result.
Stocks I am watching closely or recently invested into for 2019:
Mayne Pharma (ASX: MYX) - still monitoring
MYX is a pharmaceutical company that develops and manufactures branded and generic products, which it distributes directly or through distribution partners in Australia, USA, Europe and Asia. It has two drug development and manufacturing facilities with one based in Australia, and the other in US.
The US remains the world's largest pharmaceutical market, representing almost 44% of global sales. This is a huge opportunity for a company like MYX. The US market is incredibly dynamic, with potential regulatory changes to bring down drug prices and vertical mergers of drug store chains. MYX was relatively stable throughout this tumultuous time in 2017/18. The CEO, Scott Richards, suggests that this industry is more focused on profitability rather than volume and top line sales growth.
Following an almighty run up in early 2018, MYX fell backwards likely due to the lack of any FY19 guidance in the 2018 AGM address. Whilst not ideal, the industry is operationally defensive, and it has proven to stabilise in FY18 under Scott Richard's watch. The US drug price declines appear to have stabilised, and there is a pipeline of new generic products to come onboard to help continue driving sales growth in 2019, and thus expansion of gross profit margins.
Trading on a trailing ev/ebit of 30x, means that MYX is hovering at the low to mid range of 14x to 72x. On that basis, the stock looks undervalued, and could possibly be trading on towards mid range, at ~40x, rather than 30x. This implies there is growth in earnings not priced into MYX, but the pipeline of new generics (like Halobetasol Foam, which is a dermatology product) supports this re-rating that should happen in time.
Furthermore, the FY18 investor presentation paints a fairly bright FY19 outlook that appears to have been forgotten by the market recently. The possibility of bolt on acquisitions in the pharmaceutical industry can be immediately EPS accretive, providing further support to the earnings of MYX, as industry consolidation continues.
As 2019 appears to be a more volatile year than 2017/18, holding a stock with stable earnings and defensive fundamentals, like healthcare, may be a safe bet. I will be watching this stock closely, but the share price of ~75c looks reasonably undervalued.
Xero (ASX: XRO) - entered at low $40s
XRO provides a platform for online accounting and business services to small businesses. XRO delivers application software for small business owners, accountants and bookkeepers. For 2018 in terms of subscribers, Australia has 981k, United Kingdom has 355k, North America has 178k and Rest of the World has 65k.
This looks like a stock that can double its revenue base in the next 2 years. The catalyst for 2019, is that the UK is forcing the digitisation of tax returns (through the "Making Tax Digital" reform by 2020) for small and mid-sized businesses, in which XRO's product can be a beneficiary. Furthermore, the reforms for payroll tax in Australia (through the "Single Touch Payroll" reform), may also drive further demand for electronic solutions, like XRO's, for small businesses in Australia.
Operating sales grew to NZD 484m in FY18, and reached the first positive EBITDA and operating cash flow for a full year, for the first time ever. The top line sales has also shown significant progress over several half years.
I can confirm, this product is world-class. Back when I used to work as a cadet in the audit team of Deloitte Private from 2015-17, I remember getting a temporary account to login to the XRO platform for a client, and I did almost 90% of my audit through the login that I got. It cut so much time for asking for substantiating documents from the client. I could see the serious value add in the product, and many clients were adopting this platform. The only reason any client left the product, was because they 'outgrew' it, as the book-keeping eventually became too cumbersome for XRO, otherwise they would remain on the platform. Perhaps though, for future growth, XRO could begin to focus on a platform for larger clients?
For valuation, the trailing price/sales metric is ~12x, which shows that XRO trades on the lower end of the historical range between 9x to 71x. With the growth to come from AU and UK reform, and potentially additional penetration in subscribers in the US (although that remains to be seen with the number of competitors in US), it could be fair to assume a price/sales somewhere in the low to mid-range as being a fairer valuation, i.e. towards 20x.
On a net cash position, XRO appears to have a strong balance sheet, as supported by the 13x interest coverage ratio. With its capital light business model that is showing signs towards generating profitability soon, it appears to be a stock that could survive the volatility in 2019.
When compared to MYO, their product does not come nearly as close to XRO in terms of product design, interactivity and ultimately value add. Not as many audit clients in Deloitte used MYO. Instead, they preferred XRO over MYO. Note that KKR is currently proposing a $3.40 takeover offer (previously $3.77 but downgraded after due diligence by KKR) for MYO, which is likely to go ahead as the MYO board are recommending that shareholders accept the proposal.
Part 2 Conclusion:
The portfolio is currently positioned in such a way, to anticipate further market volatility. This has meant a selection of companies whose earnings are less sensitive to market cycles (i.e. which can grow in stormy waters so to speak). Some sectors that may perform better than expected, of which I have some exposure, include banking/insurance, logistics, plumbing, and pharmaceuticals (very soon).
As we enter 2019, nothing is ever certain. As an investor, all we can hope to do is humbly remain consistent with the process that we have, and trust in the process of stock picking that works for each of us. That also means remaining calm whether the market is greedy or fearful.
I look forward to this new year. As mentioned before, I will be working full-time in February 2019, and so the frequency of posting will reduce. It may happen also, that the substance of content that I post will change too for the sake of my clients (and better to be safe than sorry on this).
Once again, I thank those who got through this almost 10000-word yearly report (if you include parts 1 and 2). Fittingly, I want to end with a quote from Ben Graham's 1949 book, "The Intelligent Investor" which reads:
"But investing isn’t about beating others at their game. It’s about controlling yourself at your own game."
Kind regards,
Michael Li
