May 2014 Update on US Corporate Earnings Season

Invast Insights
Week Commencing May 5, 2014

www.invast.com.au | 1800 468 278
This week we look at the following topics:
Monthly portfolio review, sell in May?
We update our three portfolios with outlook summaries.
Bank earnings season underway, ANZ overvalued?
Australian banks are reporting this month. Are they priced to perfection? We
explore.
Update on US corporate earnings season
We look through the key numbers and pinpoint where we think the US markets
are heading.
Technical update on the copper price
The most important industrial metal. We tell you where it is going.

Monthly portfolio review – sell in May?
All three of our portfolios continue to track in positive territory despite the
huge volatility on the Australian market. As the iron ore price falls from
around US$120-130 per tonne to US$105 per tonne. Many investors have seen
the value of their mining shares follow the same direction lower. None of our
portfolios hold any direct mining shares and this has been intentional
throughout the year.
We continue to see our most conservative portfolio – the Drawdown Phase
portfolio – performing above target. The Wealth Creation portfolio remains a
little disappointing but still remains in positive territory. We added three new
stocks last month which we think will be excellent profit generators into the
future. We took losses on some positions earlier this year because we have a
firm stop loss policy. This helps minimise any nasty surprises which is
necessary for any growth investor.

Back to the Drawdown Phase portfolio and the excellent results! It’s not every
day that you see the most conservative portfolio shooting the lights out but it
is a feature of how we think about portfolios at Invast – we don’t benchmark
to an index, we just etc. expectations and try to deliver on them at an
absolute basis. The Wealth Preservation portfolio has seen some stability
return with standout performances from Woolworths and Woodside
Petroleum – both star performers over the past few months.
We were also fortunate to book a nice fully franked dividend from
Woolworths in two of the portfolios while the share price has rallied. Westfield
is starting to rerate slowly, still below our entry level but the market is finally
starting to see what we have been talking about over the past few months.
We think Westfield shares can continue to rise above $11 per share and should
hold that level as dividends are paid in the next few months.

We wrote an article last week about stocks likely to enter into our three
portfolios. If you missed it, you can read it by clicking here. The key priorities
are Toll Holdings and Macquarie Group. We are inclined to take profit on
Woodside Petroleum and add some Macquarie to the portfolio. We are also
contemplating adding Toll Holdings because of the solid 5% fully franked
dividend yield to the Drawdown Phase Portfolio as the TAHHA mature this
month.

We will have around $9,8000 to invest in Toll. We think the business is stable
and leveraged to a turnaround in the domestic economy. The AMP and
Goodman notes are holding steady and providing a nice income stream, it’s a
shame that we didn’t take on board the additional risk a few months ago via
the Healthscope notes (the business now looks to be subject to a takeover
with plenty of interested parties) but our focus here is to be comfortable. The
Drawdown Phase portfolio is running at an annualised return rate of 8.3%
which is above target and might even rise higher as more dividends are
booked.
So in summary, we plan to replace the matured TAHHA notes in the portfolio
with Toll Holding shares at a price of $5.28. We’ll hold off selling Woodside in
favour of Macquarie until next month. Macquarie has just reported a solid set
of numbers and will be buying back shares on market as of the time of
writing. We need to spend a little bit of time digesting the earnings numbers
and response to shareprice before making the switch. With the Toll Holdings
position, we need to act quickly since the TAHHA notes have matured as of

the beginning of May. Stay tuned for more updates, but for now all looks well
on the portfolio front!
Bank earnings season underway, ANZ overvalued?
Three of the big four Australian banks will report their earnings in May.
Commonwealth Bank is the exception, it has a June balance date for its
financial year and tends to report its earnings with most other industrial
companies in February and August. Our preference in the space remains ANZ
for the following reasons:
*ANZ is one of the few Australian
organisations that is legitimately leveraged
to the growth of Asian economies. It’s not
just about having a branch or office in Asia,
it’s about cementing business relationships.
ANZ has been working hard on this over the
past decade, it’s not an easy achievement. It

takes time and as a bank which is in the business of pricing risk, there will be
losses in Asia which we haven’t yet seen on a large scale. ANZ’s business in
Asia has grown at a compound annual rate of around 36% over the past few
years which is a multiple of the growth rate in the much more mature
Australian market.
*ANZ not only has business assets in Asia but it actually ‘gets Asia’. What we
mean by this is ANZ understands the culture, the business realities and the
situation on the grown. Many western companies have tried to impose their
way of doing business in Asia as a means to generate profit. In the banking
space this leads to disasters – western financial institutions can make profit
for a short period of time but when things heat up and the economy cools,
they are often the largest depressed sellers. We feel that ANZ understands
what it takes to be successful in Asia and has built its business around the
Asian market environment as opposed to exporting its Australian bank into
Asian markets.

* ANZ understands the benefits of integrating its Asian growth strategy into
its core Australian market. Your author was recently walking past an ANZ
branch in Hurstville – a suburb of South Sydney which has a very strong
Chinese speaking population. He noticed the branch was designed,
positioned and aimed at facilitating Chinese speaking business. The signs
were written in Chinese, the ATM machines were multi lingual and the staff
were all trained to deal with the realities of dealing with the Chinese speaking
market. Your author spoke to the bank managed who said that ANZ is one of
the few (need to confirm this) Australian banks that actually lends to Chinese
investors who wish to purchase assets in Australia. This integration is key to
building regional relationships, the same way that HSBC for example has
become a truly global organisation with portability in its services.
* The above is one anecdote only but the numbers don’t lie either. In markets
it is dangerous to just base one’s investment conviction on a single anecdote.
We admit this firmly and accordingly, we analyse ANZ’s recent report card
below.

The first thing we look at when a bank reports its profit is margins and asset
quality. The earnings of a bank can be distorted by many different factors.
Banks earn their money different to a super market. A super market’s earnings
are a function of how much product it sells, the balance sheet adjustments
are limited to certain inventory treating items. For a bank, the numbers can
really be subject to many elements at management’s discretion.
Your author covered the Australian banks during the global financial crisis in a
previous role, we saw just how quickly earnings can change for a bank based
on certain balance sheet risk items arising. For example, a bank’s
management team may determine a certain corporate loan is a performing
loan. But if the company files for receivership tomorrow, even though the
account is up to date, the reality might mean that the bank would need to
immediately take a write down on that loan if it thinks that it cannot recover
a 100% of its face value. That’s why here at Invast we spend so much time on
asset quality.

Most of the financial press and analyst community focus on earnings and
dividends. We think this is a secondary issue. If I take $100 from you and pay
you $5 or $6 return, the difference between the two amounts is 20%
($1/$5*100) and so I could report this as a 20% increase in the amount of
money I am paying you back. But what really matters is that $100 which I have
taken from you. If the value of that $100 is now worth $90, the profit that I
have paid you is completely offset by the $10 destruction in value to your
investment. Banks tend to have a habit of increasing their earnings gradually
– the $5 to $6 example – while slashing the value of their loan book overnight
in market downturns – the $100 to $90 example. So just be aware of this, the
global financial crisis has taught us to never blindly trust any global banks
ever again.
The good news for ANZ is that the loan book looks reasonable as of the end
of March this year. Impaired assets (bad loans) as a proportion of the loan
book at low at only $3.6bn. There seems to be good provisioning set aside for
problems, individual provisioning currently covers around $1.5bn or 41% of all
bad loans. ANZ can get away with us as long as things down turn sour quickly.

One of the best ways to see where loan quality is heading is by looking at
mortgage arrears. This is a good lead indicator for problem loans. A loan
might be in arrears but doesn’t necessarily turn into a bad loan unless the
bank things that the chance of it being repaid falls below a certain probability
event. Loans which have been in arrears by more than 90 days have actually
increased from $1.8bn in September to $2.0bn at the end of March. We don’t
know how many of these loans are from Australia or from the Asian business.
What we are seeing though is loans in arrears between 30 to 60 days rising
from $1.5bn to $2.0bn. This needs to be watched closely, we don’t think the
majority of this is due to the Australian business given record low interest
rates, low unemployment and rising house prices. ANZ’s total loans which are
in arrears totals $13.0bn compared ti $11.8bn at the end of September. To put
this into perspective, ANZ has only allocated $4.3bn for all bad loans – those
which have already gone bad and those that are in arrears but not yet in
default status.

Our point here is this – ANZ may have reported a nice headline growth rate in
cash earnings of 11% which caught all the news headlines BUT its loan arrears
are rising and perhaps not rising in the Australian market which is its core
business. Eventually if the arrears continue rising and snowball into problem
loans, there will be a need to raise provisioning and take some pain. Profits
will be impacted, this is a big IF event but it’s one that needs to be factored
into any scenario analysis. We’ll get a better idea of why ANZ’s arrears are
rising when we see number out of Westpac, if the trend is similar then we can
assume this reflects the dynamics of the Australian mortgage market. If
Westpac’s loan arrears vary from ANZ, we must draw the conclusion that
arrears are rising in Asia.
So we don’t doubt the Asian growth strategy, we actually like it and think ANZ
is well placed in the next decade to capitalise from Asian growth. But we are
naïve enough to just accept everything a bank tells us. We are a little cautious
on the rising arrears profile and think that eventually ANZ will need to take
some pain from a slowing rate of growth in Asia. It might make some bad
decisions along the way have book loan losses – that’s life in banking.

This will come as a surprise to the market but not as a surprise to us. We
protect ourselves from this probability but factoring in a margin of safety into
the price we are willing to pay for ANZ. The best way we think to value a bank
is by using a Price to Book ratio. The price the market is willing to pay for the
bank compared to the value of equity the bank actually owns in its business.
On this measure, ANZ’s total book value (total value of its equity) as of the
end of March was valued at $47bn. In contracts the market is valuing ANZ
shares at approximately $93.5bn. We calculate the latter by taking the ANZ
share price and multiplying by the total number of shares on issue. The result
is a Price to Book ratio of around 2x. It’s not a big number but it definitely isn’t
cheap either. ANZ’s total arrears make up about 30% of its total equity value.
This is before any large, risky corporate loans blow up. Perhaps they won’t
eventuate and things will go along smoothly. Given the experience of other
banks during the global financial crisis, we just don’t feel comfortable taking
this plunge. We think ANZ probably deserves to trade at a Price to Book ratio
of 1.5x – 50% premium to its equity value. This would equate to a share price
of around $25-$26.

In the past we have said we are willing to wait for ANZ to fall back to around
$27-$28 per share before we start adding it to the portfolio. This might never
eventuate but it’s a risk we are prepared to take. We don’t see an immediate
reason to buy ANZ even though ANZ is our preferred pick among the
Australian banks. There is a big difference between a preferred pick within a
bunch of stocks and an investment worth buying. One is a relative measure,
the other absolute and we think absolute choices are what our clients should
be focusing on. With that in mind, we are happy to sit back, relax and see how
the Australian banks perform over the coming few years. We won’t hold any
of them in the portfolios because we want to be able to sleep at night. When
we see over reaction in the market, we will take the opportunity to jump on
board and buy them. We aren’t bearish, we are just being prudent in our
investment approach.
Update on US corporate earnings season
We published a report on the Invast blog and subsequent Invast Insights

report on 7 April 2014 previewing the upcoming US reporting season. We
made the point that the risk reward ratio was making it difficult to be long
the Dow Jones Industrial Average. Since then the Dow has fallen but also
recovered in recent sessions to be fairly flat, in the vicinity of where we
initially advised taking a short position. We still think we Dow is set for
declines and the risk reward characteristics make it difficult to go long here, in
any case we have always held the view that our stop loss level would be set at
16,650 which is about 100 points away from the current price as of the time of
writing. We maintain our short view. We take this opportunity to provide
some running commentary on the key Dow Jones Industrial constituents and
how their earnings numbers have come in. Most of the names have no
reported and so we thought this would be an appropriate opportunity to
update the market on the numbers. We published the chart below in early
April.

We focus our result analysis on the shaded names – Visa, 3M, Boeing, United
Technologies and American Express.
* Visa – The stock is down for the month as the result missed expectations on
the revenue front. Net income for the three months ended March 31 rose 26%
to $1.6bn, or $2.52 a share, from $1.27bn, or $1.92, a year earlier, Foster City,
California-based Visa said yesterday in a statement. Adjusted earnings per
share, which exclude a tax gain, were $2.20, two cents better than the average
estimate of 31 analysts surveyed by Bloomberg. Revenue climbed to $3.16bn,
missing the $3.18bn estimate.
* 3M - The stock rallied nicely last month, one of the key names dragging the
Dow back higher. Earnings were in line with market expectations with
revenue up 3% to US$7.8bn and earnings at US$1.79 per share. Sales in the
healthcare unit rose nearly five per cent and were also higher for the
industrial, safety and graphics, and electronics and energy divisions. Sales
dipped in the consumer business, which ranges from stationery and office

supplies to home care products.
*Boeing - A fairly flat month for the stock, trading within a very tight range
between US$120-130 per share. Rising jet production helped Boeing post a 14
percent rise in adjusted net profit in the first quarter, beating estimates, and
the company notched up its full-year forecast. The first quarter results
reflected a weak comparison with a year ago, when Boeing delivered just one
787 Dreamliner in the first quarter of 2013. Deliveries were halted that month
after two incidents in which batteries on the planes burned, prompting
regulators to ground the global Dreamliner fleet for three months.
*United Technologies – Poor month for the stock, stock drifting lower
following the results. Nothing really there to get the market excited. New
equipment orders at Otis, a division of United Technologies and the world’s
biggest maker of elevators, escalators and other “people-moving products”
(like moving walkways), increased 9% for the quarter due to 27% growth in
Chinese orders. United Technologies said that new equipment orders in its

climate, controls and security segment increased 1% organically with growth
in HVAC (heating, ventilation, and air conditioning) products as well as fire
and security products offset by a decline in demand for container
refrigeration products in the Transicold brand.
*American Express – Another stock which has seen a poor month, market
totally unconvinced by the earnings numbers. Struggling to rise back above
US$90 per share. The company reported net income of $1.4 billion for the
period, a 7.7% increase from last year, on the back of increased spending by
card members. The card payment network’s net income margin expanded to
17.5% from 16.2% in the same quarter last year. Earnings per share (EPS) for
the quarter were $1.33, a 16% increase compared to $1.15 in 1QFY13. The
market needs to see this type of growth given the high price to earnings ratio
which we highlighted in our chart above. Lacked the strong conviction some
were looking for!
Our Senior Technical Strategist Vito Henjoto has just re-run his numbers and
provided the following analysis with respect to the Dow Jones position. His
points are:

* Key resistance located at 16650 – in line with our previous comments above
* Immediate support located at 16350 followed by 16150.
* Trend changing support located at 16000
* Medium Short term is neutral as long as price is within this 650 points range
(16000 – 16650).
* Stochastic also indicating potential overbought market in the short term.

Image: US30 daily chart via Invast MT4 platform

Technical update on the copper price
The brief copper rally over the past month faces tough resistance close to the
61.8% (around US$3.14/lb) off its fall in February – March this year. As can be
seen on the Daily chart below, copper has also failed to close above the
Ichimoku cloud. The combination of 61.8% retracement and the inability to
overcome Ichimoku cloud resistance suggests a potential for downtrend
continuation. The level that could stop this from happening is at the key
US$3/lb mark. Any daily close below this level could trigger further selling in
copper.
The Stochastic Oscillator is also supportive of this view at time of writing as
price comes off the overbought condition. Even though technical levels are
pointing for a move lower in the medium short term, we like to be on the
positive side of things that the move lower will likely be less aggressive
compared to the drop two months ago. Downside support below US$3/lb is
located at US$2.98/lb and US$2.93/lb both of which are Fibonacci retrace-

ment of the recent recovery. We do expect these levels to hold any further
drop in Copper prices should US$3/lb fails to support the market. Position
traders could look to re-enter the copper recovery on bounces from either
US$2.98/lb or US$2.93/lb.
Chart courtesy of TradingView.com
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May 2014 Update on US Corporate Earnings Season

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