Views at a Glance / Income Report; FMG & GMA - Hold or Fold, plus two small cap opportunities (FMG, GMA, IVE, CNU)

By Market Matters 11 April 18

Income Report; FMG & GMA - Hold or Fold, plus two small cap opportunities (FMG, GMA, IVE, CNU)

Market Matters Income Report 11th April 2018

Some optimism creeping back in to the market yesterday after a period of Trump fuelled volatility, however this morning US Futures have dropped (off -0.44% at 11.18am) which has put some pressure on our market – the ASX 200 currently down ~16pts. Material and Energy the only sectors in the green today but off earlier highs.

Turning focus to the MM Income Portfolio, there have been couple of areas that have caused some short term pain, namely the pullback in the hybrid space which we’ve covered in recent notes (we see this as a buying opportunity), while a couple of MM Income Holdings have been under pressure. We’ll address these and look at two smaller cap income opportunities in today’s note.

In terms of the MM Income Portfolio, the portfolio was up by 0.85% for the  week, while the ASX 200 was up by +1.06%. Since inception (5/7/17) the portfolio has gained 5.24% tracking above the market and above the portfolios benchmark. (cash rate + 4%). We added the new CBA Hybrid (CBAPG) to the portfolio with a 5% weighting. The note is trading at $98.47 as of close yesterday putting it on a margin over bank bill of 3.67% at current prices. This remains a buy at these levels given there is a distinct lack of supply now coming to market for the remainder of the year and recent weakness is overdone in our opinion. The recent WBC issue also looks cheap – in fact cheaper than the CBA trading at $96.70 putting it on a margin of 3.83% over the 90 day bank bill rate – which sits at 2.04%. Both securities now pay (grossed for franking) in excess of 5.70% as at close yesterday.

Two of our weakest holdings – GMA & FMG

Genworth (GMA) $2.29

We’re currently showing a paper loss on to mortgage insurer Genworth of ~15% as at yesterdays close seemingly underestimating how concerned investors are about a property crash in Australia. That’s obviously one reason for the stock suffering of late, however there’s also a few other factors at play;

  • We know GMA is cheap trading on 10x with a forecast yield over 10% plus franking however they’ll likely have flat earnings going forward. The main factor of weak earnings in recent times has been an increase in lending standards from major banks which effectively reduces the demand for mortgage insurance
  • We bought on the thesis that very well flagged flat / lower earnings means less insurance which means less risk and ultimately less capital requirements, so capital would flow back to shareholders.  That view still stands however when they reported they essentially pushed back expectations around when that capital could be released.   
  • The parent company (US listed Genworth) still owns 55% of GMA, and they’re likely sellers given they have plans to reduce / restructure debt. An overhang of stock reduces the natural demand in the market

We still like GMA technically but need to see a close back over $2.40 to become bullish – the market is very negative this stock and it will simply take some ‘less bad’ news to see the stock higher.

Genworth (GMA) Chart

Fortescue Metals (FMG) $4.44

We’re currently showing a paper loss on the Iron Ore miner of ~8% with the price of Iron Ore weakening after we added it to the portfolio, however there’s more at play here and digging deeper creates some cause for optimism.

  • FMG’s mined ore has a lower Iron content than the benchmark product. Because of that, their customers pay a lower price per tonne – effectively a discount. Over time, this discount has been 20-25%. Right now, the discount is around 35%
  • As we’ve covered previously, the question is, will this discount widen (get worse), stay where it is, or track back to historical levels (get better)? Fortescue reckon it will revert back to the norm while the producers of higher quality ore (Rio for instance) disagree – so there lies the conundrum / opportunity.
  • On the 9th January the discount was at its worst – around 40% - since then the discount has started to close, now around 35% so it’s tracking in the right direction. This won’t be an overnight theme but clearly the direction is now starting to favour FMG.
  • The main reason for the widening discount is environmental curbs reducing steel production which reduces Iron Ore demand generally however it especially reduces demand for lower quality ore. As steel production declines, steel prices go up and margins expand on the steel being produced, so ‘paying up’ for higher quality ore makes sense (input costs become a lower proportion of final product). Without digging further into the details, Fortescue would actually benefit if steel prices declined but their discount tracked back towards historical norms – which seems plausible / probable.
  • The iron ore price is obviously key here too and we’ve seen a number of analysts become less ‘optimistic’ on prices for the rest of the year, even the Govt is now forecasting $51.70  (currently ~$65) for Iron Ore (use that number with a healthy degree of scepticism) in fiscal 19. However looking at the Futures price, clearly some stability is emerging in the short term.

We like Fortescue in the short term, however given our bearish view on the Australian dollar, and high correlation with Iron Ore, we’ll be using strength in Fortescue as a selling opportunity – with a near term target of $4.60

Iron Ore Futures Chart

 

Fortescue Metals (FMG) Chart

 

Two small cap income opportunities (IGL & CNU)

IVE Group (IGL) $2.18

An old school printing business utilising new technologies to dominate the market + it’s clearly cheap. Thinking more broadly for a second, we all get bombarded with marketing emails and the majority rarely get opened – their validity / success is on the decline. Printed brochures however are expensive and were generally superseded by more targeted digital forms.

That obviously had an impact on your traditional printer however the tide seems to be turning back to printed & delivered marketing material using the data captured through loyalty programs to make it targeted to the consumer. As it stands this is a very fragmented industry ripe for consolidation but it requires bigger investment in more advanced printing technology to take advantage of the opportunity – simply many smaller operators will be unable to capture the market.  IVE is in a very good position to take advantage of these trends over time and right now the stock is cheap. Their customer base is strong (Woolies, Tabcorp, Foxtel, QBE, American Express, Coles, Westpac, Resmed) to name a few, and although their earnings profile is sluggish now, they’re priced for it, with the potential upside in better earnings + a multiple re-rate while they are likely to pay a ~7% fully franked yield along the way (based on ~65% payout ratio).   We like IGL below $2.10

IVE Group (IGL) Chart

Chorus (CNU) $2.82

The Telstra of old - this is a New Zealand based telco company that was spun out New Zealand Telecom in 2011 – its duel listed on the ASX and in New Zealand with a combined capitalisation of ~$3bn (ASX listed cap of $1.6bn) . Most investors are currently ‘anti telco’ however we think this stock has some substance as a longer term yield play. As suggested, this is a stock more like the TLS of old, when it owned the network and ‘rented it out’ to other users. In the case of Chorus, it owns 100% of the copper network in New Zealand and will own 80% of the new Fibre Network that is being rolled out over the next 3 years. This is an open ended network that lets other companies piggy back off their infrastructure. They essentially work with phone and broadband providers who access the Chorus network, package up and sell to customers. They have what TPG is now building in Australia & Singapore. So in the coming years CNU will own the lions share one of the world’s best networks with internet speeds 50x times (according to them) of what our NBN white elephant is delivering in Australia.

The stock has been on our radar for some time however the investment case was reinforced when meeting with L1 Capital a few weeks ago – the soon to be listed hedge fund that own 12.5% of CNU. They obviously talked their own book however they made some interesting points – most of which were covered in a video on Livewire – available here

The main risks that we see, and these were reinforced in the above video is around the impact of higher interest rates. This is an infrastructure stock priced off yield and rising rates will provide a headwind. The other is around regulatory risk over the next 12 months and finally given the exposure created by L1 essentially making this their ‘pin up’ stock, the price has risen and therefore it’s not particularly cheap. We like CNU but nearer $3.40

Chorus (CNU) Chart

 

Conclusion (s)

The hybrid market now looks cheap with recent weakness creating a buying opportunity

Looking after the weak links in a portfolio is important and today we covered FMG and GMA – two of our weakest.  

CNU looks interesting nearer $2.40, IGL looks good under $2.10

Have a great day!

James & the Market Matters Team

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.

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