Investment Matters

Positioning for a difficult economy

Positioning investments for a difficult economy

The short story

1.  The deteriorating consumer environment is adversely affecting not only retail stores (e.g. Myer) but also more broadly.

2.  Some of your investments are exhibiting ramifications of the current economic environment.

3.  But each investment is well positioned, and their investment propositions remain sound.

The investments

Some clients own one or both of two securitised debt investments: namely a pool of auto loans, and a pool residential property loans. [See footnote 1 for details]

First Samuel conducted extensive due diligence on these investments before acquiring them, including the involvement of a debt specialist.  The pools have characteristics such as low LVRs (Loan-to-Valuation Ratios), reserve accounts and low arrears.  They are also set with different tranche / ratings levels, that provide a structured risk profile.

First Samuel clients have owned these investments for some time and, based on the low prices clients paid; the considerable headroom to the underlying assets; and the quality of the assets, we are not at all concerned about them.  

Update this week

We receive monthly updates on these investments, including the key health indicator of arrears (debt holders who have not made repayments on time).  We have seen a quite small, but nevertheless meaningful, tick up in the arrears of all three pools. 

What does this mean?  The arrears increase reflects growing and fairly broad based rise in the difficulty debt holders are having making loan repayments.  This in turn reflects an increasing level of financial stress across the Australian community.  It is apparent that factors such as high consumer debt levels, high underemployment, interest rate increases (and thus higher interest payments, for example on investment property loans), limited wage growth, and a burgeoning cost of living (e.g. electricity, housing) are starting to bite. 

More broadly

We are seeing this trend across the broader range of our investment universe. 

Most prominent is retail.  Recent editions in the What Matters This Week section of Investment Matters have highlighted the number of retailers downgrading financial guidance (most recently Oroton), or worse still going out of business (Top Shop is teetering).  Additionally, for well over a year now, we have been quite conscious of this trend in the retail REIT sector (owners of shopping centres).  We think many will face a distribution crunch soon (i.e. distributions or income will fall). 

And an interesting tid-bit crossed my desk this week: retail analytics company ShopperTrak indicated it has seen a 7.4% decline in retail foot traffic in Apr-17, as compared to Apr-16.  In fact every month of the last 12 months has experienced a decline in foot traffic as compared to the previous corresponding period.

But it isn't just retail.  At least one company with exposure to the building sector (which is, along with retail, a significant contributor to Australia's economy) is calling the top of the building cycle.  Car sales are a canary of economic health, thus the earnings downgrades from AHG and AP Eagers mentioned above is notable.  Furthermore, many companies, including ones we invest in such as Southern Cross Media and Pact Group, are clearly facing headwinds in relation to their trading conditions (albeit in both these cases we do expect overall profits to increase, per share, this year, but ultimately not due to external economic conditions – they are both very well run businesses and “going their own way”).  These businesses however tell us that more people are deferring spending decisions or cutting back on discretionary spend as they are finding things tough, making trading “patchy”.  

But most importantly, positioning

What this is all pointing to is a difficult economic picture and one that seems unlikely to abate anytime soon.

As a result portfolio and financial positioning becomes even more important than normal. When the tide goes out (even if only modestly and for a bit), we finally get to see who is wearing bathers and who isn’t (as someone famous once said).

Need to be careful of exposed and highly priced investment areas and just be sensible

We see sectors with a high dependence on modest to strong economic conditions as particularly vulnerable, and it is no surprise that the banking sector (on top of its myriad other issues) is starting to creak. 

In the end a 6bps charge against liabilities is nothing compared to even a modest pick-up in arrears and bad debts to profits (and therefore dividends). Obviously this also flows through to anything that is discretionary - retail in particular is, and is likely, to continue to find things tough going. Even the “good” brands/businesses.

We also see the property sector (which is exposed increasingly to either interest rates increasing or conditions deteriorating – the ultimate no-win situation for unit holders) as “difficult” given where asset prices are.

Our strategy for all times is to consider downside first, and upside second (and make sure the upside is worth it). As a result, clients hold a broad range of assets exposed to sustainable growth areas regardless of difficult (or good for that matter) economic conditions, that can (in total) sustain and ultimately grow their profits and dividends to us (even though we will always have some which will struggle in certain conditions, whilst others are flourishing). It is worth restating that during the GFC First Samuel portfolios saw dividends from its companies increase.

Where assets have become expensive (above our assessment of value) we have sold (or been trimming exposures), and when we can’t find things (that make sense) to buy, we don’t. 

As a result in recent years our cash levels have tended to rise and we currently have 24% (plus a number of hidden cash piles…) in clients' equity portfolios and 16% in property, and also surplus cash (of around 10%) in each of our Alternative Securities' and Income Securities' portfolios. We also tended to having very defensive portfolios as prices have risen.

Ultimately therefore if economic conditions do deteriorate further we are very well positioned to both handle the short term impact, and look to make longer term gains (by picking up good long term investments when they become cheaper) from these conditions. 

Conclusion

A number of First Samuel's investments are experiencing the current difficult economic conditions.  But the investments have been actively positioned accordingly.

[1]  The two investments are:

Liberty Auto 2015-1, Class D, maturity date 10-Feb 2024, interest rate BBSW 30d + 4%, currently returning 5.625% (clients with an Alternative Securities allocation).

Sapphire 13 2014-1, Class D, expected maturity date Nov-18, interest rate BBSW 30d + 4.25%, currently returning 5.875 (clients with an Income Securities allocation).