Raw material inflation: Picking the winners and losers

Raw material inflation: Picking the winners and losers

Patrick Hodgens, Managing Director & Portfolio Manager

Costs are rising. Raw material inflation is coming through the supply-chain across industrial stocks. As a result, earnings pressures are emerging in many companies with exposure to raw materials. We have seen this in companies with exposure to oil (such as transportation, rubber or plastics) and pulp (i.e. Paper and building materials). Share prices have fallen as a result of downgraded earnings.

This article takes a closer look at some of the companies impacted by rising raw material costs, as well as where we are seeing the risks and opportunities. We conclude that now may be the time to invest in companies that have been oversold due to cost inflation concerns, particularly those that are able to pass rising costs through to their customers.

The losers

The Australian equity market has seen a number of companies downgrade FY19 earnings due to rising raw material costs. In October, James Hardie downgraded earnings after reporting 2Q19 results. FY19 profit guidance was reduced by approximately 6% citing increases in key input costs such as pulp, freight and cement. The share price subsequently declined 15%.

In our view, the James Hardie share price decline is an opportunity to buy a high-quality business, with solid growth, at a compelling valuation. Over the medium-term, we expect input costs to revert, while James Hardie should be able to deliver strong earnings growth underpinned by high single digit revenue growth through a combination of market and share growth in the US housing market.

Ansell is another company negatively impacted by rising raw material costs. Ansell manufactures and sells gloves and other protective rubber and latex products in the healthcare and industrial sectors. The key raw material inputs for Ansell are highlighted in Chart 1.

Rising raw material costs are a major headwind for Ansell’s earnings. Key raw material inputs including Fibres and Yarns (for example, Cotton) and Nitrile Latex have seen significant price rises over the year, up 13% and 27% respectively. In August, the company’s management downgraded FY19 earnings guidance by approximately 7%, resulting in a 9% fall in the share price. The Ansell downgrade highlights the impact higher raw material prices can have on profit margins, particularly for companies unable to increase prices and pass these costs onto their customers.

Chart 1 – Ansell Raw Material Input Costs (% FY18)

Source: Company data

What happens next? Picking the future winners

Some companies are better placed than others. There are companies in favourable industry structures that are able to pass rising costs onto their customers. Below we highlight two companies that we believe meet the above criteria.

Qantas Airways

Since July 2018, Qantas has fallen by approximately 11% on the back of rising cost concerns, in particular higher oil prices. There is no doubt that higher oil prices impact Qantas’ earnings. However, what makes Qantas unique is its ability to pass these higher costs through to customers. Over the past year, we estimate Qantas has increased its domestic airfares by 7%. At the same time management are continuing to deliver cost out initiatives to offset the impact of higher fuel costs.

As the domestic market leader in a rational duopoly we believe Qantas is well placed to raise ticket prices to offset the impact of higher future oil prices. At current valuations, trading on a price to earnings multiple of 9.4x vs global peers at 12x – in a more favourable industry structure – Qantas continues to represent a compelling high conviction investment in portfolios for our clients.

Amcor Ltd

Amcor is the global leader in flexible consumer packaging. One of the key raw material inputs into Amcor’s flexible packaging business is resin (plastic), which reached new highs in April 2018. However, Amcor has contractual raw material inflation pass through to its underlying customers. Over the short term, there is a lag of approximately 3-months to recover raw material cost increases. However, over the medium-term, Amcor is well placed to pass almost 100% of raw material cost inflation through to its underlying customers.

In August, Amcor announced the acquisition its largest competitor Bemis for US$6bn. Bemis enhances Amcor’s position by giving it a strong position in North America in addition to Amcor’s existing European and emerging market positions. The acquisition truly establishes Amcor as the global leader in packaging, able to offer global solutions. With a solid track record of generating value from acquisitions, good organic growth and a compelling valuation, Amcor is a high conviction position in the Firetrail portfolios that is well placed to navigate the current market environment.

Conclusion

Companies with exposure to raw material inflation will continue to see earnings pressure into FY19. As stock pickers, the key question we are asking ourselves is who are the winners and losers impacted by rising raw material costs?

In our view, investors should be wary of companies in highly competitive markets with a non-differentiated product, which may not be able to pass rising raw material costs on. Companies in market leading positions such as Qantas and Amcor who are able to pass higher costs onto their underlying customers will fare better in this environment. Businesses with strong earnings growth such as James Hardie, which has been sold-off heavily also represents a compelling long-term opportunity for our investors.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Diversifying your portfolio to weather market ‘down days’

Diversifying your portfolio to weather market ‘down days’

Patrick Hodgens, Managing Director & Portfolio Manager

Investors received a timely reminder yesterday that equity markets do not always rise. For only the second time this year the Australian equity market fell by more than 2% in a day, returning -2.7%. The only larger daily decline this year occurred on February 6 when the market fell -3.2%.

During the week the market has fallen -5%, whilst the Firetrail Absolute Return Strategy has delivered positive returns of 1.2%, outperforming the market by over +6%. When uncertainty and volatility begin to show themselves, adding a market neutral strategy to your portfolio can be a good way to diversify your returns to weather a market downturn.

With markets at all-time highs, we believe now is the time to add an uncorrelated source of returns like the Firetrail Absolute Return strategy to your investment portfolio.

The largest drawdowns over the past 20 years 

Equity markets can be volatile. Despite being a great investment over the long term, there have been significant drawdowns as highlighted in the chart below.

ASX largest drawdowns over the past 20 years

Source: Bloomberg

The largest drawdown was the Global Financial Crisis (GFC) when the Australian market fell over 50%. These significant falls can have a severe impact on your portfolio’s returns and can take a long time to recover from. The market took over five and a half years to recover from the lows of the GFC.

The key question investors may be asking is how do I avoid these significant market drawdowns?

Some investors try to time the market and move between equities and cash. However, in over 30 years investing in equity markets I am yet to come across an investor who can time the market with the accuracy and consistency required to add value.

One of the great investors of our time Peter Lynch sums market timing up wisely, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections.”

Diversifying your portfolio to weather market ‘down days’

Rather than trying to anticipate the next market downturn, a far more prudent approach is to mix in a portfolio of uncorrelated assets that can weather different market environments. Adding alternative investments to a diversified portfolio is also a good way to hedge your portfolio’s exposure to equities and provide an alternative source of returns.

In our experience managing market-neutral strategies, you can diversify your portfolio for the ‘down days’ by adding alternative strategies to your portfolio that mitigate two key risks prevalent in equity market investing:

  1. Market risk – Reducing your portfolios net market exposure to zero at all times ensures portfolio returns are not affected by market movements
  2. Macroeconomic risk – Reducing your exposure to unpredictable macroeconomic risks such as interest rate movements, currency fluctuations or political decisions is key to reducing the volatility of your portfolio’s returns. Whether and when the China/US trade war is resolved or predicting interest rate rises are binary bets that can either significantly amplify or reduce portfolio returns. In our view, you need to reduce your exposure to these key risks and focus on investing in companies from a fundamental perspective, rather than unpredictable macroeconomic themes.

An alternative investment from Firetrail 

The Firetrail Absolute Return Strategy is a market-neutral, alternative investment strategy that invests in Australian shares but hedges its exposure to the underlying share market, with a portfolio of short positions that are equal to its long positions. It is designed to deliver returns that are uncorrelated to, or independent from, movements in the underlying share market.

The portfolio has a history of delivering uncorrelated returns, particularly during market drawdowns. As the chart below highlights, during the strategy’s full history, there have been 15 monthly market drawdowns shown in blue. Of these, the strategy (in green) has only has two drawdowns where the market was also negative. It is a true alternative source of returns uncorrelated to the underlying share market.

ASX 200 Monthly Drawdowns vs Firetrail Absolute Return Strategy Composite Returns

Past Performance is not a reliable indicator of future returns
Source:*Composite returns using Macquarie Pure Alpha Fund returns. Pro-rata adjusted to apply to current management fee of 1.5% to the performance history since July 2015. Combined with Firetrail Absolute Return Fund returns since inception on 14 March 2018. The Firetrail Absolute Return Fund employs the same investment approach as was used by the same investment team that managed the Macquarie Pure Alpha Fund until October 2017.

In a market that has fallen over -5% in a week, the Firetrail Absolute Return Strategy has delivered positive returns of +1.2%, outperforming the market by over +6%.  Over the past week we have benefited from a focus on fundamentals with long positions in defensive companies Amcor Limited, Northern Star and Woolworths which have all outperformed relative to the market. Importantly, the short portfolio has provided significant downside protection, delivering +0.3% of the total 1.2% outperformance during the week.

Conclusion – Now is the time to diversify your portfolio 

It can sometimes take a timely market correction to remind investors of the benefits of diversifying your portfolio. In particular, if you are looking to hedge some of your equity market exposure risk, the Firetrail Absolute Return strategy is an alternative investment strategy that stays truly market-neutral. Providing returns that are independent of the underlying share market and reducing your portfolio’s exposure to unpredictable macroeconomic risk.

With markets at all-time highs, and uncertainty and volatility beginning to show, we believe now is the time to add an uncorrelated source of returns like the Firetrail Absolute Return strategy to your investment portfolio.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Two golden shorting rules

Two golden shorting rules

James Miller, Portfolio Manager

Short selling shares aims to profit from share price declines. Short selling is a very different proposition to going long. Not only is your upside capped, and downside unlimited – but you also have a to pay a fee to borrow the stock. The easy answer can be to exclude shorting from your portfolio completely. However, at Firetrail Investments we believe there are significant benefits to be gained from shorting, and that investors should consider allocating a part of their portfolio to shorting.

In the article below we outline ways to obtain short exposure through managed funds in Australia, and also two of the golden rules that we follow at Firetrail when uncovering opportunities for stocks to short.

How do i get access to shorts in Australia?

When looking at managed funds, there are broadly two categories of funds that offer shorting. In our view, the most important decision that investors in these funds must make is the overall level of equity market exposure desired. The two categories are:

  1. Market exposed funds, or otherwise known as long short funds. These funds have a positive exposure to the equity market. The direction of the equity market is the best indicator of returns – if the equity market falls in absolute terms, then it is likely that these funds will have also fall. Common long short funds in Australia have 130% long equities, and 30% short equities – giving 100% equity market exposure.
  2. Market neutral funds are funds where exposure to the equity market has been minimised or eliminated. These funds, such as Firetrail Absolute Return, have short positions equal to their long positions meaning the equity market exposure has been minimised. Returns are not dependent on whether the market is up 20%, or down 20%, but instead by whether the manager has chosen the right stocks to buy long, and right stocks to sell short.

Whilst I have narrowed down the funds to these broad two categories – within the categories there are managers with different styles (value, growth, pairs trading etc).

Two golden rules we have on shorting

Shorting is the opposite to going long. It requires a different psychology when investing. Our experience in shorting has provided two key lessons that are applied when finding shorting opportunities.

1.     Ignore Valuation

Valuation can be a strong indicator signal to buy a stock as a long position. But it’s not so good on the short side! Stocks can remain expensive on valuation for long periods of time….and even get more expensive. Holding a short position in a stock that has a high valuation can be a dangerous investment proposition.

Take a look at the case of CSL over the past five years. It’s been a great performer – driven by not only earnings improvement, but also a significant increase in its valuation. This can be seen in the increase in the Price to Earnings Ratio from 20x to ~35x in the chart below:

Source: Factset

Under these circumstances it could be argued that CSL is expensive, and we do not necessarily disagree with this. But in our view, it will likely remain at its current level until we see a catalyst occur. In the short-term share prices tend to follow earnings, and a catalyst to short the stock would be if our research suggested that they would not meet market expectations. Currently this isn’t the case for us – and CSL isn’t a short position.

2.     Don’t hold on to shorts forever

“Time in the market, rather than timing the market” …….is not true for shorting!

Controlling your timeframe for shorting is critical – the longer you hold on to a short the higher the risk is that the share price will rise (and hurt your returns).  We advocate holding shorts for a shorter period of time than you would hold most of your long positions. Be opportunistic in looking for the catalysts.

A great example of the importance of managing a timeframe is the example of Spotless, which was the subject of a takeover offer from Downer in March 2017. Just 3 weeks earlier, Spotless had reported its first half 2017 financial results, which had resulted in brokers downgrading earnings forecasts by 20%. The share price fell 18% over two days, and over the next 3 weeks the short interest increased to 6% of the company. It was then that the takeover bid from Downer arrived – at a 60% premium to the price at the time. A painful day for the shorts!

Source: Bloomberg

Holding on to a short position after a catalyst has occurred, like the Spotless earnings downgrade, is the riskiest time to be short. Not only are company boards and management under immense pressure to improve earnings and the share price, but it is also a time where possible suitors could make a play for the company. Managing the timeframe for holding a short position is one way of minimising this risk.

Shorting is a valuable tool 

There is a different mindset required to short successfully. Not only can shorting be used to reduce levels of equity market exposure, but shorting can be a great contributor to returns in a portfolio when rules are followed.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Three reasons shorting can benefit your investment returns

Three reasons shorting can benefit your investment returns

James Miller, Portfolio Manager

Most investors place their bets on share prices rising. There is a lot less focus placed on shorting, the betting that share prices will decline. Shorting is done by borrowing shares for a small fee, selling them on the market, and then buying those shares back at a later date. With shorting a profit is made if the share price declines during your holding period.

Currently in the Australian equity market just 2% of the bets being made are short bets. To put this in context the dollar value of Australian shorting is $29b. A big number, but tiny when compared with the ASX200 market cap value of $1.86 trillion.

Looking at the US equity market, the level of shorts is 6% of the market.  In this context of global developed equity markets, Australia is a relatively underpenetrated shorting market. Firetrail Investments believe that there is not only significant alpha that can be found by shorting stocks in Australia, but also that there are plenty of opportunities for this shorting.

1. Shorting opportunities are abundant 

Even in strong years for the Australian equity market, there are many stocks that fall. The ASX200 price index rose 8.3% in the year to 30 June 2018 – not a bad return! But as can be seen in the table below – the variation of returns across the market was significant:

Source: Firetrail, Bloomberg

In the year to June 2018 there were 95 stocks that rose more than the market’s 8.3% return and 127 stocks that rose in absolute terms. But what is most interesting is those 73 stocks that fell. These are the stocks that would have generated you a return from shorting.

Understanding the reasons for these stocks falling is the first step in understanding how to pick stocks to short.

2. There are risks, but shorting can also be rewarding

Shorting can be risky, and it is by no means a “set and forget” strategy. Losses are unlimited, and your maximum upside is 100%. So why even bother shorting?

The reason shorting can be attractive is that whilst over long periods of time most stocks and equity markets rise, in the short term the story is very different. Changes in expectations will drive changes in share prices in the short term. We believe there are two catalysts that cause stocks to fall in the short term:

  • The first reason is that current earnings expectations are not met. An example of this is Asaleo Care (AHY), a tissue manufacturer, which fell 49% during the month of July 2018. The company released a trading update to the market which pointed out rising input costs and increasing competition were affecting profitability. Average 2018 broker earnings forecasts for the stock fell 42% after this announcement.
  • Secondly, future earnings expectations may be downgraded. This can typically be from a change in market share, a new competitor entering an industry, or loss of a contract.  Whilst earnings expectations in the short term may be met, future earnings estimates will be reduced. In our experience share prices typically capitalise this future loss immediately.  Sigma Healthcare (SIG), a distributor to Australian pharmacies, announced in July that it had lost its largest customer Chemist Warehouse. This resulted in no change in the current year’s earnings – but a whopping 53% earnings downgrade for FY21. The stock fell 40% on the day this was announced.

Source: Firetrail, Factset

The way to pick these catalysts is through fundamental research of individual companies and an understanding of the industries that they operate in. Once the earnings catalyst is identified, timing is then critical.  If we think a stock will downgrade current earnings when they announce earnings in August, we will be short for the August announcement. Holding on to short positions for long periods of time increases your risk of positive share price movement – for example from a takeover.

3. Shorting requires a different mind-set

As opposed to investing long, we believe valuation is not a great indicator for shorting opportunities. You need to put valuation aside when you are shorting.

Just because a stock might screen “expensive”, it doesn’t mean it is a great short opportunity. Domino’s Pizza (DMP) was arguably expensive in 2013 when it was trading at a one year forward Price to Earnings ratio of 25x. But 3 years later it was at a 55x Price to Earnings ratio. Domino’s Pizza did eventually fall, but it was due to current earnings expectations not being met.

Rather than focusing on valuation, we believe the focus should be on earnings expectations. If our research suggests that earnings expectations, either current or future, will not be met, the stock can be a short candidate.

Summary: Shorting can be a valuable addition to your portfolio 

Shorting opportunities are abundant – every year there are stocks that fall, despite the return of the overall market. By researching and identifying the catalysts for these stock declines, shorting can be a significant contributor to alpha in your portfolio. The key is to understand the risks versus the rewards when shorting and acknowledging that shorting is very different to investing long!

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Why the hurdle for M&A activity in Australia is getting higher

Why the hurdle for M&A activity in Australia is getting higher

Eleanor Swanson, Analyst 

“I have no hesitation in favouring consumers over the shareholders” – Rod Sims, Chairman of the Australian Competition and Consumer Commission (ACCC).

In Australia, there are on average 300 domestic company mergers and acquisitions (M&A) each year. Based on our analysis, we expect the ACCC to get much tougher on mergers in the future. This research insight covers the highly concentrated nature of Australian industries, why the ACCC is about to get tougher and finally, why current outdoor advertising market mergers are unlikely to proceed.

What is the purpose of the ACCC?

The ACCC is the guardian of the consumer. It is responsible for ensuring that a merger will not have the effect of substantially lessening competition in a market or that likely public benefit from a merger outweighs the likely public detriment.

Australia industries are concentrated

Only a handful of players dominate industries that are used by the average Australian every day. But just how concentrated are Australian industries?

The best way to measure market concentration is using the Herfindhal-Hirschman Index (HHI). It is a metric used by regulators in assessing whether competition in an industry would be significantly reduced post-merger. It is calculated by squaring the market share of each player and summing them together. For example, 3 players with 33% share each would produce a HHI score of 3,267.

More concentrated markets have higher HHI scores. The below chart shows the HHI of five industries, contrasting Australia against the less concentrated US market.

Chart 1: Concentration Australia vs US – HHI of select industries

ACCC merger approval is getting tougher

There are three reasons we believe the ACCC is increasing its focus on contentious M&A activity.

Firstly, the ACCC is reducing the number of public reviews undertaken each year. In the past, ~50% of mergers underwent public review, this has dropped to just 11% in FY17. Less volumes of reviews give the ACCC more time to focus their efforts on specific cases.

Secondly, the ACCC is increasing the number of notices issued as part of its evidence gathering process. In the past year, the ACCC has doubled the number of notices issued. The success of improved evidence gathering was recently proven by the outcome of the proposed sale of Aurizon’s Queensland intermodal business to rival Pacific National. The sale was terminated by Aurizon after the ACCC released its statement of issues which alleged the deal would substantially reduce competition on interstate routes. Deals between APN Outdoor and oOh!Media, South 32 and Metropolitan as well as Camp Australia and JAG were similarly abandoned in 2017 due to ACCC objections.

Thirdly, the ACCC is now the only regulatory authority that has the power to approve a merger. Prior to the recent parliamentary reforms, approval for a merger could also be granted by the Australian Competition Tribunal (ACT) and the Federal Court. That meant merger participants could bypass the ACCC. The ACT has failed to block a merger in over 20 years and was thus an attractive option for merger parties desperate to get a deal done.

Implications for proposed mergers in the Outdoor advertising market

During 2018, two mergers have been proposed in the Outdoor advertising space, which if approved would see the industry consolidate from four players to two. oOh!Media has bid for Adshel. JCDecaux has bid for APN Outdoor.

The Outdoor ad market is 5% of the total Australian advertising market. The Outdoor ad market includes billboards, street furniture, transport locations and retail locations.

The key to the ACCC’s assessment of these two proposed deals is how they define the market in which these companies operate. Based on ACCC commentary, we believe the review will consider:

  • Collective Impact – The impact on competition of the mergers collectively, rather than separately
  • Outdoor ad market – It is likely the review will focus only on the Outdoor market. That means, the ACCC is unlikely to consider the broader advertising market including TV, online and print.

Applying these two assumptions, we calculated the HHI of the outdoor ad industry pre and post- merger. As shown in the below chart, the concentration of the outdoor ad market would increase 63% if both mergers were approved.

Chart 2: Concentration of the Australian Outdoor industry pre and post-merger vs European outdoor market – HHI

Given the industry is already highly concentrated, with an HHI above the ACCC’s 1,800 threshold it appears unlikely the two mergers will get through as proposed. Greater market concentration and reduced competition in the Outdoor ad market not only impacts the rate advertisers pay but also the rental rate the ad space property owners can realise.

Conclusion

The ACCC clearly has renewed focus and power to block contentious M&A activity in the Australian market. Given the high level of concentration within Australian industries, we believe this focus is likely to result in the ACCC blocking more M&A. Most notably, major consolidation in the outdoor advertising market is unlikely to be approved in the current form.

Will the ACCC continue its crackdown on future M&A? We think so.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

Pinnacle Fund Services Limited and Firetrail believe the information contained in this communication is reliable, however its accuracy, reliability or completeness is not guaranteed and persons relying on this information do so at their own risk. Subject to any liability which cannot be excluded under the relevant laws, Firetrail and Pinnacle Fund Services Limited disclaim all liability to any person relying on the information contained in this communication in respect of any loss or damage (including consequential loss or damage), however caused, which may be suffered or arise directly or indirectly in respect of such information.

Timing is everything

Timing is everything

Patrick Hodgens, Managing Director & Portfolio Manager

Timing is everything. This fact of life is true with just about every decision we make.

Many investors believe timing the market is everything. Selling out of equities before the market has a downturn can be a very lucrative strategy, if you get the timing right. And with hindsight it always looks obvious. However, the factors leading to a downturn are often unpredictable.

Timing the market, while good on paper, can be challenging in practice. At Firetrail, we believe timing the market is THE HARDEST decision an investor can make. This article looks at the theoretical attraction of timing the market, why it is challenging in practice and finally a look at timing the GFC. In our view, timing the market is a speculative, high risk and low return strategy.

Timing the market – attractive on paper

To prove this, we conducted analysis on the largest negative returns on the Australian equities market over the past 25 years (more than 7% drawdown). The chart below highlights that there were 16 negative returns over 7%.

Source: Firetrail, Factset

The average size of the drawdowns was 15%. But the biggest drawdown (the GFC) skewed this quite significantly. Taking out the GFC, the average drawdown was 13%.

What is clear from the data is that if you could time the market, avoiding the 16 largest equities market drawdowns over the past 25 years would have added significant value to your investments. However, could you have predicted the catalysts and the timing to perfection?

The statistical chance of getting every market timing call right to the day is about one billion to one. Not even Warren Buffet is skilled enough to win that bet!

Timing in practice – close enough is NOT good enough

The big fall in the GFC skews the results, so we have temporarily taken this out of the next part of our analysis.

Our research showed that the worst market downturns are almost always followed (or preceded) by the best market rally’s. Excluding the GFC, if you timed the equity market downturns correctly BUT you were just one month early or one month late in your timing, you would have returned the same result as being fully invested.

That’s right! You would have effectively wasted your research time and effort to come up with the same result as being fully invested.  This excludes transaction costs of executing these market timing events.  So, you have picked the market downturn correctly 15 times in a row, but you had to be correct within one month on every occasion just to breakeven. The chart below highlights the returns of timing (and miss by a month) vs the market returns. An expensive, risky and unrewarding result.

Source: Firetrail, Factset

Timing the GFC

Now, let’s look at the elephant in the room. The Global Financial Crisis (GFC).  From peak to trough, the market fell over 50%, in a 17-month period ending in March 2009. If you timed the GFC to perfection, you would have saved a significant amount of money.

But consider this. Following the fall of over 50%, would you have been brave enough to step back into the equities market in April 2009? The market performance during the GFC was the worst return in over 30 years. However, the BEST return of the market in the past 30 years was between April 2009 to December 2009, where the market rallied +62%.

Now clearly when a market falls 50% it needs to rally 100% to get back to square. But the point is, the biggest upswing the market has seen for 30+ years was straight after the worst downturn.

Summary

Is timing the equity market a lucrative investment strategy? If you time it to perfection, the answer is certainly yes. However, in practice the information and skill required to time the market with the accuracy required to add value consistently is challenging at best. Getting the timing wrong by just one month would leave you with the same result as no action. And that excludes transaction costs.

At Firetrail, we believe the best thing we can do for clients is to stay fully invested in the equity market over the long-term and add value through bottom-up stock selection. In our view, it is a more sustainable way to generate returns for our clients than to place speculative bets on cash versus equities.

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Firetrail Investments Pty Limited ABN 98 622 377 913 (‘Firetrail’), Corporate Authorised Representative (No. 1261372) of Pinnacle Investment Management Limited ABN 66 109 659 109 AFSL 322140.

Any opinions or forecasts reflect the judgment and assumptions of Firetrail and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in this article are estimates only and may not be realised in the future.  The information is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. This communication is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. Any persons relying on this information should obtain professional advice relevant to their particular circumstances, needs and investment objectives. Past performance is not a reliable indicator of future performance.

Interests in the Firetrail Absolute Return Fund (ARSN 624 135 879) and Firetrail Australian High Conviction Fund (ARSN 624 136 045) (‘Funds’) are issued by Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371. Pinnacle Fund Services Limited is not licensed to provide financial product advice. A copy of the most recent Product Disclosure Statement (‘PDS’) of the Funds can be located at www.firetrailinvest.com  You should consider the current PDS in its entirety and consult your financial adviser before making an investment decision.

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