Invast's 2013 Telco Stocks Update And Global Financial Market Correlations

Invast Insights

Week Commencing October 14, 2013

www.invast.com.au | 1800 468 278

This week we look at the following topics:

1.0 Telco stocks update – how our picks have fared

2.0 US reporting season preview

2.1 Earnings beat rate

3.0 Market correlations

3.1 Currency Triangulation

3.2 Using correlation to detect market anomaly – Gold & A$ divorce

4.0 Client question and answer


1.0 Telco stocks update – how our picks have fared

One of the hottest sectors of the market in recent weeks has been the

telecommunications and software space. In our Invast Insights report

published on 9 September 2013, we mentioned three stocks in this sector as

potential growth opportunities as part of a wider discussion around growth

in software services and the “new economy”. If you didn’t read the report or

haven’t had time to go through the archive then unfortunately the following

section will cause you to sigh. The stocks we mentioned were Adslot (ADJ),

Mobile Embrace (MBE) and Moko Social Media (MKO). We’re pleased to say

that all three stocks have delivered positive results in a sideways trending and

often very difficult trading environment.

The best performing stock has been Mobile Embrace which has rallied 81%

since we wrote our report a month ago. The stock had run up strongly before

we decided to write about it and when we did we noted “We have been

skeptical of the run-up in share price but we thought we would


lay down our prejudice against MBE and have a closer look” The lesson here is that when a sector is hot and a stock is earning the attention of savvy investors, it’s worthwhile putting aside your prejudices (sometimes ill-fated like ours) and focusing on what the market is interested about. It is also very important to be disciplined in a rising and euphoric market and so with that said, any subscribers to this report who acquired the stock on the back of our notes may consider banking profit.

Is there the prospect of Mobile Embrace rising further? It is possible but not enough for us to sacrifice a healthy profit already on the time in such a very short timeframe like one month. The company is still at a relatively small market capitlisation of $40m and some would criticise for taking profit on something that is in a upward trend. One of our staff members queried the research team in a recent morning meeting saying “shouldn’t you run your gains and cut your profit?” We agree that this is true when trading markets or even investing at times, but the extent of the gain should also be taken into consideration. It was also Warren Buffett who once said “be fearful when others are greedy and be greedy when others are fearful”. We don’t propose to be Buffett fans but we love taking profits and so that remains our primary motive here. Cash in the bank is king.


Adslot has also had a solid month, adding around 19.7% during the period and at one stage the stock hit a high of 8.2 cents per share which would have presented a gain of around 34%. This is one we will be hanging onto, it sits in both our Wealth Creation portfolio which we update on a monthly basis and our list of 15 hidden gems which we published on 26 August 2013. The business announced an acquisition a few days after we published our report, acquiring Facilitate Digital, which will create an expanded global footprint. The acquisition owns the Symphony workflow and trading platform which is purpose built to meet the needs of large media buyers in the display advertising space. Adslot says over $800m of online media spend is processed via Symphony each year and growing. We aren’t sure at this stage just what that means in terms of earnings to the parent company.

Moko Social Media hasn’t performed as well as the other two stocks on the list but the share price is flat which is good enough. The stock has already doubled over the past year and so gains from here need to be result driven. The market capitlisation is in line with Adslot and Mobile Embrace. We’ll update these three stocks before the Christmas break to see how things pan out. The stock changed its name during the month from MOKO.mobi and just as well.


* Table: Data as at 10 October 2013

2.0 US reporting season preview

US companies have commenced reporting their earnings for the quarter

ending September. While most of the market is focused on the debt ceiling

and government shutdown, there is the prospect that both are addressed but

the market falls because corporate earnings don’t meet estimates. The S&P500

is currently trading on a 2013 price to earnings ratio of around 15x and is still a

few percent away from its all time high. This isn’t exactly a high price to

earnings ratio, the average between 2004-2007 was somewhere between 16-

18x earnings, depending on which earnings base is used for calculation.


The real story for the S&P500 though is the recovery in earnings and

expectations of future growth.

Corporate earnings are what drive stock prices. The trend in earnings is what

traders are really looking at. Average earnings for the S&P500 have grown

from around US$61.60 in 2009 to an expectation of US$111.30 currently. The

market is expecting earnings of around US$123 next year, which is around

double the amount of earnings in 2009. There would be a 5 year gap between

the two numbers and given the collapse in markets during the 2009 earnings

season, there is scope for the improvement. But if September quarterly

earnings break the positive earnings momentum, traders will take this as an

opportunity to sell off stocks on expectations that brokers will cut earnings

estimates.

So which stocks will be a bellwether? For the S&P500 we think the following

list will dictate market direction.


* Table: Data as at 10 October 2013


These top ten stocks represent around 17.7% of the S&P500 and will set the

tone for market direction. The first of these stocks to report will be Johnson &

Johnson – two days before the debt ceiling deadline. The market is currently

expecting Johnson & Johnson to book third quarter earnings of US$1.32 per

share which is a mild decline on the prior quarter. The stock is trading on a

price to earnings ratio of around 15.5x future earnings, a slight premium to

the market. Anything short of US$1.30 per share will disappoint the market.

Microsoft and Apple will report after the debt ceiling deadline – both trailing

at a price to earnings ratio discount to the market at 12.5x and 11.8x

respectively. The discount reflects the fact that the market is slightly cautious

on the current earnings base and so both these companies will not only have

to show growth but show that the earnings base is sustainable.


2.1 Earnings beat rate

One thing which many analysts look for during quarterly reporting season in

the United States is the “beat rate” – a calculation that looks at the final print

of earnings and compares them with consensus market expectations. It tends

to give an overall indication of corporate health relative to expectations and

we all know that the market prices stocks on future expectations of earnings.

The earnings beat rate isn’t a perfect number because expectations are

measured on an average basis. So say for example, the expectations for a

particular stock’s earnings are set at US$1 per share – this may have been

compiled by questioning ten analysts in the market or by asking just four of

which one might have not updated their number recently, hence skewing the

average towards an out of date figure.


For the second quarter this year, around 66% of the S&P500 companies that

reported their earnings the final number was above measured expectations.

This is higher than the long term average of 63%. Around 54% of companies

booked revenue above expectations which was lower than the 61% long term

average according to Thomson Reuters. In terms of individual sectors, some

76% of financial stocks beat expectations while for technology stocks the

figure was at 73%. The surprise factor in financials was 11% which is very

significant. The performance of financial stocks this time around will matter.

Going into the third quarter, there were 94 S&P500 companies who provided

negative pre-announcements compared to 18 positive preannouncements.

This suggests to us that around 20% of the market felt like analysts were

getting too ahead of themselves and their third quarter results would not

match preset expectations. So as we started the discussion in this section of

our report, we reiterate that the upcoming reporting season will be very

important in terms of recent momentum in stock markets – perhaps more

important than the whole debt ceiling or government shutdown

conversation.


3.0 Market correlations

Global financial markets are inter-related to one another, whether you are

looking at bonds, equities, currencies, option locally or internationally;

everything is connected and affected by any changes in the financial market.

Traders, economists and analysts look at this correlation between markets to

get an indication of where the market is going to move. The currency market

contrary to popular belief, is the largest market in the world and is the link to

almost all of the global financial market. Consider the interaction involved

when purchasing a share in a company, currencies are used for the exchange

and as such buying a share involves selling a currency.

For the reason above, understanding currency correlation is an important

factor when trading on the currency market, this is especially true when it

involves the benchmark currency, US dollar. Most major, market moving

economic data comes from the United States and not only in terms of the


currency market taking its cue on the US dollar movement, share markets globally look to Wall Street’s performance as a guidance and benchmark of market sentiment.

Correlations between markets can be classified under two classes:

Positive correlations: two markets moving in the same direction 90% of the time.

Negative correlations: two markets inversely related and moving in the opposite direction 90% of the time.

From these correlations, a trader can gauge the sentiments in the market (is there appetite for risk in the market or is the market more risk averse) which is a crucial factor in trading. A risk averse market typically saw the high yielding currencies like the AUD/USD and GBP/USD for example track lower as traders run towards a safer currency like the US dollar, Swiss Franc or the


Japanese Yen. Conversely a risk on market would likely see an increase in

global indices and high yielding currencies.

Let’s take a look at some of the global instruments traders look at for

correlations, they are not limited to currencies alone.

Negatively Correlated

EUR/USD and USD/CHF correlation is a text book example of a negatively

correlated instrument. More than 90% of the time these two pairs are a direct

opposite each other. A gain in EUR/USD typically see s a drop in USD/CHF.


Figure 1 USD/CHF VS EUR/USD source: Invast MT4


Another inversely correlated example is the relationship between the US

dollar and the stock markets, in particular the Dow Jones Industrial average

Index. A gain in the index represents risk appetite in the market, this normally

happens when data released from t he United States are good or indicative of

improving economic condition. An interest rate cut is also associated with an

increase of risk appetite in the market, as borrowing costs become cheaper,

and a nation’s currency becomes less attractive to investors.


Figure 2 US Dollar VS DJIA source: Bloomberg


Positively correlated

Positive correlation describes two financial instruments that move in the same

direction, as such one of the main purpose in monitoring positively correlated

instruments is to use one instrument as a leading indicator of the other. A

great example is the correlation between EUR/USD and GBP/USD. Very often

we find one currency leading the other in a positive correlation and in the

case of EUR/USD and GBP/USD, the interaction between the two is a little

more unique, which I will explain in the next section.


Figure 3 EUR/USD VS GBP/USD source: Bloomberg


The graph below illustrates some of the most watched correlations in the global

financial market.


3.1 Triangulation

Most currencies in the FX market seem to move in the same direction most of

the time, but in reality one typically moves more than the others.

Hypothetically speaking let's create trader A. Trader A understood the notion

that EUR/USD and GBP/USD are positively correlated, in other words both are

often found to move in the same direction most of the time. Trader A decides

to pick either EUR/USD or GBP/USD to minimise his exposure in the market.

Take a look below on EUR/USD and GBP/USD price movements:


Figure 4 EUR/USD VS. GBP/USD source: Invast MT4


Notice that while both are moving in the same direction, they rally at different

intervals, and while one rallied significantly the other remained flat. In the

above example GBP/USD rallied on the 14th of August and EUR/USD had to

wait a week for its turn.

Should trader “A” had picked GBP/USD he would have enjoy one move up but

he would probably missed out on the major move on the EUR/USD. How then

as a trader could we maximise and anticipate these moves? Which one will

actually move faster than the other?

To answer this, we need to be rid of a certain currency that exists in both

pairs; US Dollar. Doing so would leave us with EUR/GBP in which we can look

for potential changes in the strength between these two currencies.


Figure 5 EUR/USD vs. EUR/GBP source: Invast MT4


Figure 6 GBP/USD vs. EUR/GBP source: Invast MT4


Notice that during the rally in GBP/USD on the 14th of August, EUR/GBP fell

significantly, which in turn keeps the pressure on EUR/USD from rallying,

conversely on the 20th of August, both EUR/USD and EUR/GBP rallied,

keeping the pressure on GBP/USD.

By analysing the movements of EUR/GBP (even if trader “A” does not trade it),

he could have identified which currency pair is likely to move more than the

others. Currency Triangulation is the term used to look at the market in such a

way. While the original term of currency triangulation attempts to profit from

market imperfection between 3 currencies, this modern take can be used to

identify which currency pair is worth a trader's time; especially when day

trading and minimising market exposure is a goal.

The above example uses EUR/USD, GBP/USD and EUR/GBP, but there are other

triangulations out there such as AUD and NZD or even the JPY crosses.


3.2 Using correlation to detect market anomaly – Gold & A$ divorce

While correlations work most of the time, they are not 100% there are short

periods where instruments are not perfectly correlated and some trader s

await such moment to exploit these mismatches in t he market.

Recent development in the global financial market is also a concern, as we

saw Gold and AUD/USD breaking away from their positive correlation on the

back of concern over US Debt Ceiling and US Budget leading to the

prolonged US government shutdown.

It is ironic to see the market flog to t he US dollar because of their safe haven

status and at the same time Gold takes a hammering because of the risk

aversion in the market. Australian economy on the other hand remains strong

and stable, causing a de-coupling of correlation between Gold and AUD/USD.


Below is the correlation between the two last year and as can be seen, the

two are positively correlated working perfectly as a leading indicator.

Figure 7 AUD/USD vs. Gold in 2012 source: Bloomberg


And below is the de-coupling between the two since August 2013, where Gold

and AUD/U SD becomes negatively correlated.

Figure 8 AUD/USD vs. Gold in 2013 source: Invast MT4


What we can tell from the change in AUD/USD and Gold correlation is the

potential anomaly in the current market, where market is likely to be more

volatile, indecisions amongst traders and general uncertainty in the market.

Normally these anomaly do not last for long and a return to normal

correlation could signal a potential end towards the current economic threat

brought upon the market by political bickering in the Unites States.

Not all correlations are experiencing this anomaly and triangulation strategies

between currency pairs still work wonders and could assist traders in making

trading decisions.

4.0 Client question and answer

“I noticed last week that you have WESTFIELD in your portfolio. My question to

you is….why do you hold this company when the retail situation is so bad in

Australia??” – Ali, Melbourne


Ali, thanks for the question. There is so much happening in the markets at the

moment. The unemployment rate in Australia has fallen but the numbers

don’t tell the full story, the United States continues to struggle with its debt

situation and Europe is still fragile. Many investors are asking themselves

questions like – are dividends the way to go? Is it time to get into mining

stocks? Is it better to trade short term or take long term positions? Often

there is a lot of confusion and at Invast our portfolios are there to help

navigate you through the turmoil.

The trick is really around formulating an investment strategy, which we have

done across the three portfolios. It all sounds very formal, having a strategy

around your investments, but it really is one of the most important starting

point to every investment process.

Many investors think they have a strategy, but if you ask them to define it in

one sentence, they will struggle. If you're reading this, ask this question of

yourself. The most common answer is


something along the lines of: "I want a little bit of income and capital growth.

I also want to find a small-cap stock with huge returns and not lose any

money during the process.“

Basically, that's an "I want it all" approach, which we all know is not possible.

It's not just individual investors. Many companies also fail to define their

investment strategy. We met a company at an investment briefing a few

months ago, which was looking at putting together an IPO (initial public

offering) in the real-estate space. After an hour-long presentation and various

questions from the analyst team, we realised the presentation slides did not

contain a section or even sentence on strategy. It's something that is often

overlooked.

The very intelligent and experienced managing director managed to answer

the question when asked, but not having it in the presentation slides shows

how even the most intelligent investor in the market can often overlook the

most simplistic issues. So, what's the right investment strategy? That is


something that you will need to answer for yourself but something we try to

help via the portfolio strategies. Otherwise, it largely depends on

circumstances, motivations, risk tolerance, goals, and the pace at which you

want to achieve them.

What we plan to do here is show you an example of how strategy setting in

portfolios plays an important part in success. You can look at fund managers,

or even better, find companies that have strategised successfully over the

years. One of the best-performing stocks on the Australian market over a long

period of time has been Westfield Group (WDC). The company has changed

forms over the years, more so in recent history, but the focus on strategy is

something that is always front of management's mind when driving the

portfolio.

It's a simple business - build and develop shopping centres, rent them out and

manage the operation. But without a firm strategy, the business could have

easily lost its way over the years. Many property groups blew up during the


crisis, particularly larger ones in the US of comparable size. Yet Westfield managed to ride out the downturn in good shape. The strategy is simple and summed up in one sentence, which you will always find within the first few pages of a Westfield presentation to the market: "To develop and own superior retail destinations in major cities by integrating food, fashion, leisure and entertainment using technology to better connect retailers with consumers.“

The strategy changes over time. Food, for example, is now a main priority in the development and management of centres. People have to eat - and Westfield wants to feed them. Will Westfield develop in remote areas? Probably not, since the strategy says the focus will be on major cities. Are they afraid of online shopping? Probably not, since the strategy embraces technology that connects retailers and consumers.

So, does having a well-thought-out strategy make Westfield a good investment? Assets are geographically diversified: Australia 41 per cent, US 40 per cent, the UK 15 per cent and other locations the remaining amount


Please note that the Westfield Retail Trust (WRT) is a different vehicle. Total

assets under management for Westfield Group are $64.4 billion. Group

occupancy is at 97.8 per cent, with comparable growth in net operating

income of 3.3 per cent.

The brand has become iconic globally, perhaps similar to a Mercedes, Prada or

Louis Vuitton. We often complain that the Australian market lacks such global

consumer brands, but I would argue that we have the brand to house them all

in one location - shopping malls. We might not comprehend this in Australia

because we have become so used to walking through a Westfield mall, but

many developing economies around the world who seek to embrace Western

brands would acknowledge a Westfield mall as a sign of progress in their

economy.

Having Westfield flagship malls on Pitt Street in Sydney, at the World Trade

Centre site in New York and the Olympic site in London is no coincidence. It's

all part of the strategy. Does the gloss stack up financially?


Return on contributed equity is at 11.4 per cent - the return Westfield is

earning on its investments. It's not a great amount of money, but to me it

means there is scope for earnings growth. Remember, Westfield is not just an

owner of malls, it also develops and manages them. The development

pipeline has been slow in recent years, but that is a sign of prudence and

patience. Westfield targets 12-15 per cent un-geared returns on its

developments.

With property and banking stocks, chasing a dividend yield can pay off, but

the quality of dividends and growth is more important over the medium term.

Many will dismiss Westfield as expensive with a dividend yield of around 4.6

per cent unfranked. Telstra, in comparison, is around 6.1 per cent fully franked.

But it's not fair to compare the two. Westfield has huge scope for

development growth. It will continue to generate a passive income on its

current mall portfolio and brings a track record of developing solid growth

over the past few decades.


Almost half the rental income Westfield derives is from its US assets. Keep in

mind that the US is still underperforming and occupancy is at 94.4 per cent,

so growth in passive income has further scope. Telstra will give you a higher

rate of initial income, but it doesn't have the growth profile, geographical

diversity or track record of returns like Westfield.

If Westfield's dividend grows at 5 per cent annually over the next decade, this

year's 51-cent distribution will become 84 cents a share. It's by no means

guaranteed, but it's also worth noting that Telstra paid a 27-cent dividend in

2003 and paid 28 cents a share this year, so the growth has been much less.

The banks have seen a much larger rate of growth in their dividends over the

period, but for investors looking at diversifying outside of the banks, Westfield

on merit deserves to be within a well diversified portfolio. It sits in our Wealth

Preservation portfolio together with Woodside Petroleum, Woolworths, the

top 200 stocks in Australia and the top 300 stocks in Japan.


So Ali, we hope that answers your question. Westfield is a quality exposure

which over the medium to long term will do well within the portfolio. In the

short term there might be some volatility but if you are a believer in the

United States economy improving, there are few names best placed to benefit

in the Australian market when compared to Westfield.

Get more information about this topic on our resources page.

http://www.invast.com.au/resources/invast-insights.aspx






5.0 Disclaimer

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*Distributed with the permission of Invast.com.au

Invast's 2013 Telco Stocks Update And Global Financial Market Correlations

Investor Relations

Transcript of Invast's 2013 Telco Stocks Update And Global Financial Market Correlations