monthly strategic outlook april 2013

8/21/2019 Monthly Strategic Outlook April 2013

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Patersons Securities LimitedMonthly Strategic Outlook - April 2013

THE AUS TRALIAN S TOCKBROKER

ABN 69 008 896 311

This months highlights...Macro: Whipsaw Market - Neutral ViewIndustrials: Health Care Sector Reveiw - March 2013Rare Earths: Weak hands create opportunity in a rare producer


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All information and advice is confidential and for the private information of the person to whom it is provided and is provided without any responsibility or liability onany account whatsoever on the part of this firm or any member or employee thereof.

MONTHLY STRATEGIC OUTLOOK 2

IN THIS ISSUE...

Macro Investment Strategy

Whipsaw Market - Neutral View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Australian Outlook

RBA benchmark rate stays at .%; February retail sales surprise on upside . . . . . . . . . . . . . . . . . . . . . . .

Quantitative Focus

Using a Multifactor Model to Identify Investment Opportunities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

SECTORS

Banks

Competition in the Australian Home Mortgage Space is Hotting Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Industrials

Health Care Sector Review - March . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Energy

Oil & Gas: Oil prices rebound during March . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Mining and Metals

Gold The hurt continues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Specialty Metals

Rare Earths: Weak hands create opportunity in a rare producer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


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MONDAY 20 APRIL 2009



Andrew Quin - Research and Strategy Coordinator

WHIPSAW MARKET - NEUTRAL VIEW

APRIL 2013

Macro Investment Strategy

Across the major global stock market indices the most positive technically remain the US indices, while Shanghai (China), the Nikkei( Japan), and European Union (EU) markets, with the exception of the Swiss market, all look technically vulnerable. The US marketshave been supported on easy monetary policy and a view that the US economy continues in recovery mode.

With the US markets having reached record highs emphasis is naturally on the sustainability of the US recovery and companyearnings going forward. In addition this places focus on US Federal Open Market Committee (FOMC) actions and the outlook forQuantitative Easing (QE) and the continuance of stimulatory economic policy to provide support for the market.

This divergence in global markets, combined with a balance of supportive and resistance factors suggest the All Ordinaries (XAO) isset for a period of whipsawing a volatile, tight, ranging market.

Slow global growth, adds US economic emphasis

US stimulatory policy is only going to be reduced when there is clear evidence the US economic recovery is sustainable. If the USeconomy continues to improve reducing stimulatory policy efforts is inevitable. The first move would be a reduction in monthlyQE asset purchases. Under the distorted economic system now existing a reduction in asset purchases is the equivalent of a lift ininterest rates. The FOMC has stated it will maintain stimulatory buying while the unemployment rate, currently at 7.7%, remainsabove 6.5%. Monetary policy needs to track proportionally behind the US economic recovery or growth will slow. Thus the FOMCare likely to maintain stimulatory policies for the foreseeable future, however this will not stop the stock market from trying toanticipate a change in policy direction.

Commodities are mostly trading lower, particularly agricultural (grain) futures on favourable weather conditions. Although onbalance combined with metals the commodity picture looks one of weakening global demand and an unwinding after expectations

of a China economic bounce failed to materialise.

With the top end yield play in Australia capital gain wise looking a little long in the tooth and the Materials sector lacking anupside catalyst, the local market is feeling some pressure. Recycling yield is still the main focus for superannuation focused investorson the Australian market with compounded yields still offering good returns relative to cash and the Australian property market. Thisremains a positive element despite, the now, reduced attraction on the capital gain potential side following the markets strong run.

Towards a volatile whipsaw market

The All Ordinaries (XAO) has scope to trade higher to ~5,150 if US 1QTR earnings surprise on the upside in coming weeks. However,relatively limited technical support exists below the 4,950 4,900 level, with support at 4,750, and 4,650 - 4,600. Thus a clearbreak of 4,950 4,900 would warrant protecting positions quite quickly for technical traders. While those with a fundamentalview would need to see a deterioration in the US economic outlook to lighten positions, this requiring both a deterioration in the

employment and housing outlook.

Following the strong market move higher from November 2012 to the top of the 3.5 year trading range, we expect the XAO to setup a volatile tighter range as the market grapples with a lack of clarity on the US, Chinese and global recovery, and Japanese Bondmarket and North Korea pressures.

We expect the Australian and US markets to be supported on the downside by an extension of stimulatory monetary policy, a basingin the Materials sector, and attractive yields (local), and to be blocked on the upside by strong technical resistance (5,000 5,200),lack of economic growth clarity, macro and socioeconomic stressors, and ironically the spectre that the FOMC may start to back offQE efforts in late 2013 early 2014. Though current estimates are for policy to be wound back in 2015.

A view of the future could look something like the market in late 2009. A volatile whipsaw market suggesting traders will have tostay active to avoid neutral returns.

Continued page 4


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Commodities Back to the future - Oscillation around the marginal cost of production

Materials and Commodities are messing with traders minds, as it is hard to separate what is actually happening from what traderswant to happen. Metals look like they are going back to times when they traded just above and below the average marginal costof production. Though iron ore, tin and copper all look to still be holding reasonable buffer margins, but the stock market is not abeliever and is factoring in potential for a decline in prices going forward.

This back to the future effect will return the stock market focus in regard to Materials companies towards grade and productioncosts.

With China showing only lacklustre signs of growth, the hope for the Materials side now appears to be if the US can eventually dragthe rest of the worlds economy higher, assuming its recovery continues.

Chinese export import figures are released 10 April, these being one of the more accurate measures of Chinese economic performance.Of late they have tended to show a picture of reasonable exports lead by US demand, while imports, in part a reflection of domesticactivity, remain comparatively weak. Authorities in China are drying up liquidity and the country looks like it is still trying to absorbthe excesses and a misallocation of resources following Global Financial Crisis (GFC) stimulatory policies.

Pulling the wool over your eyes?What China, Japan and other central banks with their stimulatory policies and asset purchase programs have tended to forget, is thathistorically government directed economic growth and asset purchases have tended to result in significant waste and a misallocationof resources.

The GFC was a near structural failure of the financial system, but subsequently governments have tried to prop up through assetpurchases, and stimulatory policy a global economy where medium term demographics (China one child policy, Japan agingpopulation, EU economic maturity) was likely to result in a partial natural decline in economic demand and output. Effectivelyresulting in a weak period, before wider global demographics and technology once again boost global growth performance.

The global situation is not unlike when the Australian wool industry decided wool should not be sold below certain price levels andstarted to buy its own wool. This resulted in a huge wool stockpile, ending inevitably in tears. The global central banks are expanding

their balance sheets with assets to support markets in the hope that private sector demand will lift, but like the wool industry perhapsthey have set their floor prices too high distorting both production and global markets.

Page 3 continued


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Japan continues to defy the economic laws of gravity recently significantly expanding its asset purchase and stimulatory efforts.The country is targeting 2% inflation to lift hard asset values and stop what has been a deflationary spiral via simply more ofthe same policy that has not worked for 20 years. It is certainly an interesting experiment, but Japan has an aging population,strong competition from China and requires innovation to extract itself from such a downturn. But when do you hear support forinnovation to aid competitiveness mentioned by central banks? At the time of writing Japanese Bonds are under pressure followingthe increased stimulatory moves.

Central banks are trying to return to a world where significant money was made buying assets that where then sold on to others athigher prices. Its a grand experiment. The US may just get away with it, because it is historically a country of significant innovation,this assisting its competitive position.

European Central Bank (ECB) efforts do seem to be sustaining a reduced risk profile in measures such as Credit Default Swaps (CDS)and periphery yields. The ECB has done a good job of acting as a back stop to demand, but the Eurozone remains in slow growthmode and it is essentially a trade-off between future economic growth levels and how long the ECB can support the Bond markets.The Japanese approach suggests a significant amount of time, but perhaps not forever.

Again the world looks to the US

Right now the future of the global economy looks not to rest with China but once again on the US and the sustainability of itseconomic recovery.

The US indices despite being at all-time highs still look attractive, with high liquidity levels and stimulatory policy remainingsupportive. The FOMC has the US stock market back at record highs and they appear to want to keep stimulating the US economyuntil the property market and employment recovery looks sustainable.

The US is moving closer to energy self-sufficiency, technological innovation should start to flow more strongly through the systemin coming years, and the S&P500 still has upside to catch up with long term Gross Domestic Product (GDP)/inflation/dividendhistorical tracking.

While there will of course be problems along the way, we maintain a positive view on the longer term US outlook.

Alcoa kicks off 1QTR US earnings on 8 April with expectations for S&P500 company earnings to be 1.9%-3.9% lower against thesame period a year ago. Earnings expectations are low for S&P500 companies this quarter. Currently the market expects earningsfor Financials and Tech stocks to drag the earnings numbers lower before a later in the year rebound.

It is vital that the US economy and stocks continue to perform, given alternative markets both lack upside catalysts and looktechnically vulnerable.

Outlook Whipsaw

The XAO is likely to range in a whipsaw pattern through what is commonly a weaker seasonal period for stock markets following thestrong Christmas period. We are Neutral on the market on a month view, but still favour yield payers as defensives. At this stage welack evidence for an upside catalyst in the Materials sector. We see the Materials sector as yet to base and are Neutral until we seea basing catalyst or technical reversal. The Materials sector is trading down as the market unwinds after the failure of the Chineseeconomy to bounce significantly following the change of leadership and Chinese New Year. LME metals are yet to return to theirtrading bases. The Materials sector base is 9,000 (Current 9310). However, if US employment data is favourable a technical shortterm bounce of the sector could take place before base levels are hit.

The market in the US has been supported on the US growth story and its continuance. This will add emphasis to the 5 April US Non-Farm Payrolls (Consensus: 195,000, Prior 236,000) numbers, and housing numbers going forward.

A significant miss on US Non-Farm Payroll numbers would create the impression of a slowing in the US recovery picture which couldresult in a change in US market sentiment. However, a deterioration in the housing sector would be needed to complete a picture ofthe US economic recovery failing, and as yet this is not the case. However, if such a situation was to eventuate traders should lightenpositions given alternative global markets and economies do not look strong. Concerns remain for both the Japanese and Chineseeconomies, while slow growth continues in the EU.

KEY DATES:

Continued page 6

5 April US Non-Farm Payrolls.8 April US 1 QTR Earnings season starts (unofficial).10 April China Import Exports.

30/1 April/May FOMC meeting.7 May RBA meeting.19 May US Debt Ceiling extension.


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Key theme 12-Month view Primary risks Technical (XAO 4,900)

The market is likely to longterm range trade suggestingthe need to recycledividends, time, and tradepositions. A specific stockfocus is recommended.

Testing range resistance.

Neutral The sustainability of US growth Support Resistance

Sovereign credit risk and financial structuralpressures/ US Debt Ceiling negotiations/Japanese Bond market

Near: 4,900

Next: 4,750

Next: 4,650-4,600

Near: 4,950

Medium: 5,000

Primary: 5,2001- Month view Pressures on growth in China

Neutral/Bullish The pace and sustainability of globalgrowth given high debt levels

Neutral capital gains in a cyclical rangingmarket

SECTOR WEIGHTING COMMENT

ConsumerDiscretionary

Index weight Interest rates, a weaker consumer outlook and pressure from internet purchases have taken some ofthe edge off the sector outlook. Technically upside momentum is coming out of the sector.

Consumer Staples Index weight More defensive than the Consumer Discretionary sector and offering some good yields. Technicallyupside momentum is coming out of the sector.

Energy Index/Under

weight

The oil price continues to be heavily influenced by OPEC, geopolitical factors and the global growth

outlook. EU Iranian oil sanctions are also an influence. Middle East and Northern African risk is oilprice supportive. Technically the sector is ranging.

Financials Index/Overweight

Tight credit markets, margin contraction and loan book risks are negatives for the sector. Marginpressure, from tighter wholesale money markets, combined with a weak Australian property sectorare primary influencing factors in the market. However, yields remain attractive and RBA policy witha downward bias is of assistance. Technically upside momentum is coming out of the sector.

Healthcare Index weight Expected to benefit long-term by the aging population and government support. Technically upsidemomentum is coming out of the sector.

Industrials Index weight Australian dollar will hamper exports for some companies. Slow offshore demand will also drag.Technically the sector is testing resistance, with some momentum coming out of the market. Looksvulnerable to the downside.

Information

Technology

Index weight The Information Technology Index is stock specific. Technically the sector is just below resistance.

Materials Index weight Traders in the sector had anticipated a better performance by the Chinese economy by now, howeverthis has not taken place causing the sector to sell off. China is continuing to significantly drive metaldemand. Chinese efforts to manage its economy remain the primary short term risk. Technicallythe sector is trading down looking for support. A short term technical bounce could take place if USemployment data is favourable.

Property Trusts Over weight We believe the worst for the sector is behind us and the majority of ASX 200 REITs are in goodhealth and well set for the next upturn. Outside the ASX 200 investors still need to be cautious andselective, given many of these trusts have not recapitalised. We like the sector as a long term fouryear play for recovery with a good yield in the interim. Technically the sector is trending higher on alonger term chart, while some momentum is coming out of the market.

Telecommunications Index weight The sector has regulatory, competitive and technological change pressures. Difficulty predictingforward earnings adds sector risk. However, yields remain attractive. Technically upside momentum

is coming out of the sector and it is ranging sideways.Utilities Over weight Many stocks in the Utilities sector are moving to more vanilla models and so the sector is in the

midst of structural change. Avoid stocks with excess leverage and refinancing risk. Yields make thesector attractive. Technically ranging.

Page 5 continued

MARKET STRATEGY: April 2013: 1-Month: Neutral. 12-Months: Neutral/Bullish. The All Ordinaries (XAO) is trading down inwhat we expect to develop into a whipsaw trading pattern. US markets have touched record highs. US economic numbers remainmostly positive against a background of strong stimulatory policy. Chinese economic numbers are mixed, while EU credit risks asmeasured by CDS remain contained. Japanese Bond market and North Korea pressures are a market concern. The current beliefthat economic recovery is taking place will need to continue to be reflected in economic numbers in the year ahead to maintainmarket support. Yields on the Australian market remain attractive. Chinese policy lacks aggression, probably due to stress inthe shadow banking system and property market and this is pressuring commodity prices. The Australian economy is slightlyunderperforming on interest rate, government, offshore and dollar pressures. US, EU, UK and Japanese monetary policy is setat extreme stimulatory levels in an effort to lift demand. We maintain a yield and stock specific catalyst focus. We suggest longterm holders ensure dividends are reinvested and so compounded through time. The twelve month technical target is 5,200.


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RBA reiterates the appropriateness of policy accommodation and the scope for more cuts if required

The April RBA board meeting saw the bank keep its benchmark interest rate unchanged at 3.00%. Given its relatively relaxed viewon the medium-term direction of Australias inflation rate, the RBA overtly stated that scope still existed for rates to be furtherreduced should it be necessary to perk up demand levels. For the moment though the bank was happy to note that with inflationexpectations contained and with our GDP growth likely to be a little below trend over the coming year, an accommodative stanceof monetary policy was appropriate.

The bank stated that while global growth remained a little below trend, the downside risks had in its view reduced over recentmonths. Europe remained the proverbial fly in the ointment with the RBA rates decision commentary blandly stating that theContinent remained in recession. On the upside though, the US continued to enjoy a moderate expansion and growth in China had

stabilised at a fairly robust pace. Across the broader Asian region, the bank noted that growth was dampened by the earlier slowingin China and the weakness in Europe, but some signs of stabilisation were at least apparent.

The RBA highlighted further improvement in global funding conditions for financial institutions. It specifically noted that long-terminterest rates faced by highly rated sovereigns, including Australia, remained at exceptionally low levels and that borrowing conditionsfor large corporations are similarly very attractive. Share prices were, at the same time, substantially above their low points. However,the RBA also conceded that the task of putting private and public finances on sustainable paths in several major countries was stillvery much work in progress, meaning financial markets remained vulnerable to setbacks.

With regard to domestic economic developments the April RBA rate decision commentary stated that while the peak in resourceinvestment was now close, there was more scope for some other areas of demand to strengthen in short, sector rebalancing rulesOK! It specifically stated that the 175 basis points of rate cuts implemented since late 2011 were having an expansionary effect on theeconomy and that further such effects would eventually emerge.

The bank made mention of the moderate growth now apparent in private consumption spending a point reinforced by the recentlyreleased February retail sales data, which are examined blow. The bank warned though that any expectations households would goon a spending binge any time soon were wide of the mark. The RBA conceded that the near-term outlook for investment outsidethe resources sector was relatively subdued, but continued to hold out hope that a modest increase would become apparent over thecoming 12 months. The much-anticipated revival in Australias dwelling construction sector remained a slow burn.

On the costs front, the RBA remained relaxed about recent shifts in the Australian CPI and noted that labour costs were contained.In an additional positive, the bank had identified an increased focus on cost efficiencies across the domestic business sector. Andlooking ahead it believed our inflation would remain consistent with the target band of 2-3% underlying over the next 12-24 months.

However, the RBA continued to show some frustration that the A$ remained quite elevated despite the observed decline in export

prices. A still muted demand for credit was also seen as something of a surprise, although the RBA has for years now impressed uponboth households and firms the merits of lower gearing.

Retail sales again surprise on upside, but unambiguous bounce in housing construction still to occur

Headline retail sales surged by 1.3% seasonally adjusted in February, well up on market expectations of around 0.3%. Adding to thejoy, the already large 0.9% gain reported over the previous month was upgraded to 1.2%. All six of the broad retailing categoriesprovided in this ABS-prepared release managed 1.1%+ advances across the month of February. However, putting things in perspective,the value of retail sales over the three months to February 2013 was just 1.9% above the total recorded in the corresponding periodof late 2011/early 2012 and this would be much smaller again in inflation-adjusted terms.

While the retail sales revival marries up with the recovery seen of late in consumer sentiment, it does not correlate closely with thecries of pain still coming from many major and small retailers, who continue highlight the need to offer discounts to get consumers

opening their wallets. What is more, even if the January/February bounce does reflect reality, will it be long lasting? We wait withbaited breathe for a meaningful package of individual retailer guidance statements on whether the robust January/February sales datadoes indeed approximate their reality.

Tony Farnham - Economist

RBA BENCHMARK RATE STAYS AT 3.00%; FEBRUARY RETAIL SALES SURPRISE ON UPSIDE

APRIL 2013

Australian Outlook


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The ABS also recently released its February building approvals stats which in our view were only satisfactory on the surface. Yes,the headline number was up 3.1% in February, above economists consensus forecast of 2.5%. However, digging deeper, the all-important private sector houses segment edged 0.5% higher. And the approvals data were also patchy from a geographic angle, withSA enjoying an out-sized intermonth gain of 20%+, with the latter surge in large part driven by its public sector houses component(a jump that is unlikely to be reprised in March). The major disappointment was NSW, which booked a 7.7% intermonth decline.

Source: ABS, Patersons Research Source: ABS, Patersons Research

We still expect further RBA rate cuts and/or additional mortgage rate reductions

The robust retail sales numbers had interest rate hawks salivating simply because they bolstered their thesis that the chance ofanother RBA increase is remote (assuming of course the data align with reality!) More immediately, the stats will have economistsupgrading their current March 2013 quarter GDP projections.

We nevertheless remain of the view that the RBA will cut rates further over coming months and this is without any downsideshocks occurring in key overseas economies. While some wealth effects will flow from recent house price increases, the RBA rate

cuts already in place and the modest bounce in our stock market over 2013 to date, we would be surprised if these are enough todeliver sustained gains in household spending. At the same time, the contribution by the all-important mining sector to mediumterm investment flows looks set to underwhelm and the A$ would be sticky downwards if offshore monies seeking safe havenscontinue to enter our market. In the background remains the potential for some slippage in consumer confidence flowing frompolitical uncertainties ahead of the 14 September Federal election.

Retail Sales Extend Their Early 2013

Revival

0.0

0.3

0.6

0.9

Feb-09

Feb-10

Feb-11

Feb-12

Feb-13

Mthly % Chg

-2

-1

0

1

2

3

4

5Mthly % Chg

Trend (LHS)

Seasonally Adjusted (RHS)

Residential and Non-Residential on the

Rise, but Renovations Still Lagging

0

1

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3

4

Feb-03

Feb-05

Feb-07

Feb-09

Feb-11

Feb-13

$B

0.0

0.1

0.2

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0.7$B

Residential (LHS)

Non-Residential (LHS)

Alterations/Additions (RHS)


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The success of quantitative stock selection strategies across markets has been well documented. Portfolios formed on the basis ofvarious stock specific factors such as value, momentum, growth and yield have been found to earn excess returns across differenttypes of markets. By studying the behaviour of specific stocks, their cycles, and characteristics during those cycles, it is possibleto locate stocks that can outperform. Unlike fundamental investors who focus on a stocks industry, business, and specifics of thecompanys management or financials, quantitative investors evaluate the stocks statistics. The benefit of quantitative models is thatit can help investors screen a large universe of stocks into a portfolio of ideas which is more manageable. In addition, the systematicnature of quant models allows decisions to be objective. The main assumption of quantitative analysis is that patterns tend to repeatthemselves.

So which factors have done well?

Last year, the factors which have performed well have been quality, yield and large caps. However, over the last six months, wehave seen valuation factors show significant outperformance. Interestingly value tends to perform well during a market trough(accumulation phase) while momentum based factors perform better near the market peak. Intuitively, valuation strategies tendto work poorly in periods of high risk aversion. Despite this, it is important to include valuation factors in our model because whenvalue stocks begin to recover, they tend to rally strongly, especially after a prolong period of price declines. In fact, during this period,excluding value factors would significantly impair the performance of the portfolio.

We have developed a stock selection model by screening for stocks on factors which have historically generated a high correlationto excess return. To do this, we perform back-tests and assess the relationship between various factors on a stocks alpha over anextended period. For each test, companies in the universe are divided into quintiles (groups of five) based on their rank on one ormore investment factors. For example, a P/E ratio test would have stocks with the lowest P/E in the first quintile while those withthe highest P/E ratios would be placed in the fifth quintile. Returns for all portfolios in each quintile are then calculated, averaged

over a 30 year testing period, and compared to the average return over the same period for the overall universe. A strategy is saidto have investment value if the top (first) quintile significantly outperforms the universe, the bottom (fifth) quintile significantlyunderperforms, and outperformance/underperformance is consistent over time.

Our tests highlighted six key factors which stood out. The factors that provided the highest information coefficient in predictingexcess return comprised of profitability, price momentum, valuation, cash flow generation, capital allocation and earnings revisions(or earnings surprise). From a quantitative perspective, the most important factors are valuation, cash flow generation, profitabilityand price momentum. Using this information, we can combine these factors to provide a powerful screening tool across the ASX300universe.

Valuation This factor eliminates companies that are not attractively priced and includes P/E, Intrinsic Value, Yield, Price to Book,and EV/EBITDA. Specific sectors respond differently to various valuation factors. For example Price to Book is useful for propertystocks, EV/EBITDA is good for resource stocks and Intrinsic Value is ideal for industrial stocks. A widely known valuation strategy is

the P/E ratio but tests reveal that is not strong and does not work consistently across market cycles or industries. The reason for thisis bottom line earnings can be subject to distortion and earnings forecasts tend to lag sentiment. Generally speaking, companies withan EV/EBITDA below 9x tend to outperform over the longer term.

Profitability This factor works well because past profitability often serves as a barometer of a companys potential future successeg. past earnings are often reinvested in the business to produce future earnings. The key factor for profitability is return on equityas it measures the amount of income generated on an investment (equity). Investors should favour companies with an ROE in excessof 15%. Other profitability measures such as ROA do not work as well.

Cash flow Generation Free cash flow is operating cashflows less capital expenditure. Capex is subtracted because it is non-discretionary. Companies which do not maintain and expand plant and equipment cannot remain competitive. Unlike earnings ornet income, cash flow is a tangible asset and cannot be easily manipulated. A company with excess cash has the financial flexibility

to expand its business, pay distributions or repurchase shares. An ideal cash flow ratio is free cash flow to invested capital (ROIC).Companies which have a ROIC of 12% or more tend to outperform the market. Another ratio we look at is free cash flow per sharewhich needs to be positive.

Kien Trinh - Quantitative Analyst

USING A MULTIFACTOR MODEL TO IDENTIFY INVESTMENT OPPORTUNITIES

APRIL 2013

Quantitative Focus


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Price Momentum This factor simply refers to the rate at which a stock goes up or down over a specified time period relative tothe market. The success of momentum based investing is regarded as an exception to the efficient market hypothesis. Eugene Fama,refers to momentum as the premier unexplained anomaly. A simple way to measure price momentum is to consider the proximityof a stock to its 52-week high or low. Another technique might be to compare its shorter moving average with its longer movingaverage relative to the rest of the market. Stocks that scored a momentum ratio of 70% or higher tend to outperform.

A few points to note:

Certain factors work better than others in particular industries, so a more focussed sector based model may yield better returnsthan this model which is designed for the entire market.

Although earnings growth is a primary driver of stock market returns (ie. high growth companies tend to outperform), earningsgrowth alone, is not predictive of future stock market returns. Rather it is the consistency of earnings growth which drives excessreturns.

Unprofitable companies that are issuing large amounts of shares should be avoided.

Application of analyst forecasts works slightly better than the application of trailing 12 months figures.

Interestingly, financial leverage ratios, such as debt to equity, do not work very well. However, this strategy was particularly useful

during the financial crisis but not so much now.

Most Attractive Stocks

Code CompanyPrice ($)03.04.13

SentimentMomentum

ValuationEV/EBITDA

Cash FlowCash ROIC

ProfitabilityROE (%)

Quant Rank

TPM Tpg Telecom Limited 3.18 0.960 9.1 10.7 21.9 0.98

DLX Duluxgroup Limited 4.45 0.863 11.5 11.9 47.3 0.97

MLD MACA Limited 2.91 0.875 4.2 9.5 30.8 0.96

IIN iiNet Limited 5.28 0.967 5.6 8.4 19.2 0.96

CSL CSL Limited 59.28 0.847 17.6 9.0 36.0 0.95

CLO Clough Limited 1.31 0.874 9.3 13.9 21.8 0.94

TRS The Reject Shop 16.75 0.797 9.9 19.1 29.0 0.94

JBH JB Hi-Fi Limited 15.13 0.917 7.7 22.3 53.4 0.93

MYR Myer Holdings Ltd 2.94 0.867 6.6 14.5 15.3 0.91

RMD ResMed Inc 4.43 0.768 14.1 60.4 18.0 0.91

ROIC = free cash flow to invested capital; ROE = return on equity; Quant rank has a maximum of 1

Continued page 12


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Least Attractive Industrials


SentimentMomentum

ValuationEV/EBITDA

Cash FlowCash ROIC


Quant Rank

SLX Silex Systems 3.24 0.404 -80.2 -14.0 -6.3 0.14

BLY Boart Longyear 1.25 0.050 3.8 -6.8 5.6 0.15

NUF Nufarm Limited 4.16 0.083 6.1 -7.9 6.5 0.18

VAH Virgin Aust Holdings 0.42 0.296 5.6 -9.9 6.0 0.19

ARI Arrium Ltd 0.80 0.223 5.1 -2.1 4.0 0.22

MAH Macmahon Holdings 0.24 0.282 3.0 -0.5 -3.3 0.23

TEN Ten Network Holdings 0.32 0.572 16.9 -4.4 0.3 0.26

BBG Billabong 0.73 0.144 6.5 1.0 2.3 0.27

SGM Sims Metal Mgmt Ltd 9.75 0.454 10.6 -0.3 2.3 0.30

RIC Ridley Corporation 0.90 0.085 7.2 1.6 6.0 0.31

EHL Emeco Holdings 0.61 0.481 3.5 -3.7 7.4 0.31

CSR CSR Limited 2.05 0.780 6.2 -5.3 2.6 0.32

QUB Qube Holdings Ltd 1.70 0.573 10.6 -4.0 6.9 0.32MQA Macquarie Atlas Roads 1.52 0.331 37.2 1.7 2.2 0.33

EGP Echo Entertainment 3.46 0.159 8.6 2.6 4.7 0.33

TWE Treasury Wine Estate 5.72 0.709 13.2 -3.1 4.7 0.34

FKP FKP Property Group 1.55 0.614 18.2 0.7 3.2 0.38

WRT Westfield Retail Trust 3.07 0.377 16.3 2.5 5.6 0.38

AZJ Aurizon Holdings Ltd 4.03 0.744 8.8 -2.3 6.7 0.39


Least Attractive Resources


SentimentMomentum

ValuationEV/EBITDA

Cash FlowCash ROIC


Quant Rank

IGO Independence Group 3.79 -0.033 14.1 -12.2 4.1 0.06

NCM Newcrest Mining 19.56 -0.054 10.6 -5.1 4.9 0.11

AGO Atlas Iron Limited 1.08 0.017 5.0 -8.4 3.9 0.12

SAR Saracen Mineral 0.28 0.017 1.1 -10.3 6.6 0.14

SBM St Barbara Limited 1.16 0.055 3.8 -6.1 5.4 0.16

GRR Grange Resources 0.20 0.013 1.2 -0.2 2.0 0.17

OZL OZ Minerals 5.04 -0.014 3.6 0.2 2.8 0.18

EVN Evolution Mining Ltd 1.40 0.173 4.1 -10.4 7.8 0.20

GBG Gindalbie Metals Ltd 0.21 0.175 -26.1 -0.7 -1.3 0.21

KCN Kingsgate Consolidated 3.81 0.183 5.1 -4.6 6.6 0.24

WSA Western Areas Ltd 3.18 -0.028 6.1 2.7 4.6 0.26


Page 11 continued


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The importance of the home loan sector to our Big-4 banks can not be over-estimated. Home loans account for upwards of 58% ofthese four banks respective loan books (both domestic and offshore), with Commonwealth bank of Australia (CBA) and Westpac(WBC) having around 67% of their global advances in housing-related term loans. Home mortgages share of regional bank loanbooks are even larger. Given this relative importance, any shifts in the competitive dynamics in this loan segment have ramificationsfor Australian bank profitability.

Our view for some time now has been that sustained single-digit growth in Australian and NZ mortgage books will materiallyshorten the odds that our home loan providers will resort to more (1) aggressive pricing of their home loan products and (2)accommodative loan-to-valuation ratios. To not do so would risk a gradual slide in market share. Such a scenario increases the riskof some deterioration in credit quality especially if this fall away in lending standards is soon followed by softer jobs markets andsome slippage in home prices across major capital city areas. We do not see the latter becoming a major concern in the immediate

term. The RBA too noted in its March Financial Stability Review that while competition in the mortgage market had pushed somelenders to offer interest rate discounts and/or waive application fees, non-price loan standards have been broadly unchanged over thepast six months. Macro and/or credit quality worries could nevertheless potentially come into sharper focus later in 2013 if the RBAsattempts to rebalance our economy are not a success and competitive pressures in the mortgage market intensify.

Amongst the Big-4 banks, NAB holds onto price-leadership-powered home loan market share gains

This potential for competition-induced margin contraction in the Australian mortgage sector must continue to be monitored byinvestors. The latest Australian Prudential Regulation Authority (APRA)-compiled market share statistics highlight the effects ofthe most recent sustained round of price competition in the Australian home loan market. The charts below, derived from theabovementioned APRA data show up the success of the NABs price leadership campaign in the mortgage space although it doesnot show the margin contraction that accompanied the initiative!

Source: APRA, Patersons Research Source: APRA, Patersons Research

Macquarie Bank and Yellow Brick Road attempt to create a fifth pillar in home loan market

In late 2012 it became apparent that another major financial institution, Macquarie Bank (MQG), was keen to wade into the Australianhome loan market, in the process creating a so-called fifth pillar in this sector. It looks like the bank is reprising its PUMA financingvehicle of old, which was operating in the halcyon easy money days ahead of the Global Financial Crisis (GFC). This push is being

done in partnership with mortgage originators, headed this time round by Yellow Brick Road Holdings (YBR).

APRIL 2013

Banks

Tony Farnham - Economist

COMPETITION IN THE AUSTRALIAN HOME MORTGAGE SPACE IS HOTTING UP

Continued page 14

Loans & Advances - Big 4

12

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Owner Occupied Home Loans - Big 4

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Page 13 continued

HIGHLIGHTED STOCKS

SECTOR WEIGHTING Index/Over Weight

COMPANY RECOMMENDATION COMMENT

ANZ Banking GroupLtd (ANZ)

ACCUMULATE ANZ Banking Group announced an unaudited cash profit for the three months to31 December 2012 of $1.53bn, up 6.2% on the same period in 2012 (first quarter 2012:$1.49bn). Unaudited statutory profit after tax was $1.36bn. Revenue growth reflected theconstrained business environment. Reasonable volume growth, particularly in Asia, wasoffset by margin pressure in NZ and in the International and Institutional Banking division.The groups APRA Basel III CET1 ratio at 31 December 2012 was 7.7% which equates to9.7% on a fully harmonised basis, unchanged from the 2012 full year. Payment of the final2012 dividend had a 30 basis point impact towards the end of the quarter. The grouphad completed circa 50% of the 2013 full year term wholesale funding task by the end ofDecember 2012.

In November last year YBR announced the creation of some aggressively priced mortgage products. It intends launching additionalbanking and wealth management offerings further down the track. More recently, the company achieved record loan settlementsduring January 2013, with this total more than double that delivered in the first month of 2012. This uplift indicates that YBR hasgained traction via its heavily publicized Empower Home Loan product, which has a first-year teaser rate. YBR noted that aroundthree quarters of the January settlements total were refinancings.

From MQGs viewpoint, mortgages accounted for around 30% of total lending growth over its latest reporting period (the six

months to September 2012). Looking at the APRA data, MQGs lending for housing (both owner occupied and investment) was$6.25B at the end of February 2013, more than double the total reported just 12 months earlier.

Yes, all this is coming from a low base, but reports abound that the bank has materially beefed up the headcount of staff that liaisewith mortgage brokers. The bank has also recently ramped up its marketing of MQG-branded home loans. This all makes sensewhen one considers the tough trading conditions being experienced in its traditional investment banking activities.

Whether this new competitive threat has legs will be crucially dependent on the recent trend towards cheaper funding in theresidential mortgage-backed securities market being long-lived. The cheaper this funding, the more scope is there for lenders utilizingit to more keenly price their mortgage product offerings. Banks on the other hand, with more reliance on relatively expensive termdeposits, have less scope to play the pricing game (unless they opt to cross-subsidise or realise efficiencies in other facets of theiroperations). The strategic response of Australias traditional listed banks will indeed be interesting.

We still prefer ANZ and WBC; investors over-exposed to banks should consider option strategies

We retain our long-held view that both ANZ and WBC appearbetter placed from an asset quality angle. These two banksalso have the strongest capital positions under the Basel IIIregulatory regime. ANZ continues to differentiate itself fromother Australian banks with a steadily growing Asian-basedfranchise. This said, ANZ will need to quickly demonstratethat the key man risk associated with the loss of its much-respected head of International Alex Thursby can be quicklyneutralised.

The adjacent table outlines key dates in the upcomingreporting cycle.

More generally, with bank share prices now up appreciably over the past year and their prospective dividend yield metrics now lessenticing, some investors particularly those heavily over exposed to banks might want to consider some conservative optionsstrategies. For those in the latter grouping with a view that bank share prices will track sideways from here a covered call strategymight be worth a look (making sure to protect pending dividends). For those concerned that bank prices could give back some oftheir recent gains, a bought put strategy may have attraction.

Upcoming Bank Reporting Dates

Result Due Ex-Div Record Payable

BOQ 1H13 18-Apr 2-May 8-May 27-May

ANZ 1H13 30-Apr 9-May 15-May 1-Jul

WBC 1H13 3-May 13-May 17-May 2-Jul

NAB 1H13 9-May 30-May 5-Jun 16-Jul

Upcoming Bank Trading Updates

CBA 3Q13 15-May na na na

Source: Various bank announcements/websites


15/36

Continued page 16


Industrials

APRIL 2013



HEALTH CAREBen Kakoschke - Industrial Analyst

HEALTH CARE SECTOR REVIEW - MARCH 2013

Key Pharmaceuticals & Biotechnology News

CSL (CSL): re-affirmed guidance for FY13 NPAT growth of 20%Mesoblast (MSB): raises $170m at $6.30/sh, a 2.2% discount

Key Health Care Equipment & Services News

Resmed (RMD): Earnings marginally lowered after round two of US Government medical insurance competitive tender processRamsay Health Care (RHC): Entered into a 50:50 JV to expand into Southeast Asia initially and eventually throughout Asia

Sonic Healthcare (SHL): Expects FY13 EBITDA to be at the lower end of previous guidance of 5 - 10% growth

Recent Small Cap Contact

Antisense Therapeutics (ANP) To begin chronic toxicology study to support a potential future Phase IIb study of ATL1102 in multiple sclerosis patients

Capitol Health (CAJ) Announced the acquisition of MDI Group, a specialist diagnostic imaging company with 11 clinics primarily located in the south-

eastern regions of the Melbourne metropolitan area, with expected EPS accretion in excess of 25% Our price target has increased to $0.17 per share (from $0.13) and we have maintained our Hold recommendation

Mayne Pharma (MYX) Our price target has increased to $0.45 per share (from $0.42) due to a small reduction in risk rating to reflect the Companys

inclusion in the All Ordinaries Index and more investible size with a market cap approaching $300m However, our recommendation has reduced to Hold (from Buy) following the 30% price increase since our last report

Figure 1: Summary of large cap key data

Company Code PriceMC EV* PE (x) EPS Growth (%) Dividend Yield (%)

($m) ($m) FY12 FY13 FY14 FY12 FY13 FY14 FY12 FY13 FY14

Pharmaceuticals & Biotechnology

Acrux ACR 3.88 646 623 88.2 102.1 18.7 -87.2 -13.6 447.4 2.1 2.1 4.9

CSL CSL 59.23 29,459 29,891 31.4 24.5 21.7 8.8 27.9 13.2 1.4 1.8 2.0

Mesoblast MSB 6.15 1,936 1,637 - - - - - - - - -

Sirtex Medical SRX 11.07 617 569 36.7 32.6 23.4 48.0 12.4 39.3 0.6 0.9 1.4

Health Care Equipment & Services

Ansell ANN 16.07 2,102 2,308 16.6 15.6 13.7 6.3 5.9 14.0 2.2 2.3 2.6

Cochlear COH 68.05 3,882 3,941 24.5 25.3 23.6 -12.1 -3.2 7.4 3.6 3.7 3.7

Fisher & Paykel Healthcare FPH 2.10 1,139 1,248 22.3 18.9 17.4 -1.7 18.4 8.3 4.7 4.7 4.7

Primary Health Care PRY 4.96 2,495 3,521 21.3 17.0 15.0 12.6 25.3 13.4 2.2 2.8 3.1

Ramsay Health Care RHC 32.30 6,527 7,444 27.8 23.9 21.0 14.8 16.5 13.8 1.9 2.1 2.4

ResMed RMD 4.36 6,785 6,092 23.9 20.6 18.9 35.7 15.8 9.1 0.4 1.5 1.8

Sonic Healthcare SHL 13.93 5,518 6,989 17.3 16.7 15.3 6.9 3.5 9.2 4.2 4.4 4.6

Sigma Pharmaceuticals SIP 0.74 860 818 16.8 14.8 14.4 2.3 13.6 3.0 5.4 6.0 6.1

Source: Thompson Reuters consensus estimates, IRESS * FY13 net debt forecasts used for EV


16/36



Page 15 continued

Figure 2: Summary of contacted small caps

Company Code RecPrice

($)MC($m)

Net Cash($m)

Potential Catalysts(0-12 months)

Potential Catalysts(12+ months)

Antisense Therapeutics ANP - 0.01 14.4 5.1 ATL1103 Phase II trial results ATL1102 Phase II progress Global antisense transactions

Major pharma licensing proposals Global antisense transactions In-licensing additional compounds

Capitol Health CAJ HOLD 0.175 75.2 (2.1) Demonstrating MDI margin benefits Expansion of MRI incentives Solid industry organic growth

More gap-charging services Further acquisitions Potential takeover target

Mayne Pharma MYX HOLD 0.48 270.2 (11.5) Meeting FY13 guidance SUBACAP approval in Europe Relaunch of Kapanol in Australia FDA approval of Doryx

News flow from pipeline of 17 products US launch Mayne Pharma products

through Metrics distribution Launch of injectables in Australia

Source: Patersons

Sector Performance

Figure 3: 12-month index performance Figure 4: 5-year index performance

Source: IRESS Source: IRESS

Figure 5: Monthly Pharmaceuticals & Biotechnology movers Figure 6: Yearly Pharmaceuticals & Biotechnology movers


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Continued page 18

Figure 7: Monthly Health Care Equipment & Services movers Figure 8: Yearly Health Care Equipment & Services movers


Pharmaceuticals & Biotechnology Sector News

CSL (CSL) market cap $29.5bn (down 1% for month)

CSL develops, manufactures and markets biopharmaceutical products. The blood plasma industry has consolidated into a few fully-integrated global suppliers. Control of supply, scale of operations, and integration of services from blood collection to productmanufacture gives CSL a competitive advantage difficult to replicate. Industry consolidation led to favourable pricing and liftedreturns. The Companys human papillomavirus (HPV) vaccine offers a new stream of earnings, with royalty revenue from MercksGardasil and GlaxoSmithKlines Cervarix.

Revenue of US$2.5bn was 7% above the pcp or 11% higher in constant-currency terms. EBIT rose 24% to US$786m. NPAT jumped24% and exceeded guidance of 20%. EPS benefited from the share buy-back, rising an impressive 30%. The interim dividend wasUS50cps unfranked, up 33% on pcp. Revenue growth reflects, among other factors, ongoing penetration of emerging marketsand small market share gains in developed markets. Material operating efficiency gains and higher margin sales mix drove up grossmargins from 46.1% to 52.1%. The result benefited from some skewing of expenses to 2H13, in particular R&D. CSL re-affirmedguidance for full-year NPAT growth of 20%, suggesting EPS growth nearer 24%.

Mesoblast (MSB) market cap $1.9bn (down 7% for month)

MSB is a medical research and development company developing therapies that utilise Mesenchymal Precursor stem cells extractedfrom bone-marrow. The therapy is non-controversial unlike some other stem-cell therapies, while clinical trial results indicate a highprobability of success. Large underserved potential markets include heart failure patients, bone-marrow regeneration in cancerpatients and several orthopedic indications such as intervertebral disc repair. A potentially highly lucrative licensing deal with USbiotech Cephalon (now owned by Teva Pharmaceuticals) provides strong endorsement of the technology platform. Product salesare unlikely before 2015 but additional revenue from partnering deals is likely before then.

In March 2013, MSB raised $170m through an issue of new shares to existing and new global institutional investors, priced at $6.30 pershare, a 2.2% discount to the stocks last traded price prior to the announcement. Following the issue the Company will have cash reservesof $332m. Cash raised will go towards: a Phase 3 clinical trial using Mesenchymal Precursor Cell (MPCs) for treatment of degenerative

disease of the lumbar spine; a new Phase 2 clinical trial to broaden the indications for intravenous delivery of MPCs in the treatment ofsystemic inflammatory conditions; optimisation of MPC manufacturing processes and increased product inventory staff and overheads.

Acrux (ACR) market cap $0.6bn (down 4% for month)

ACR is trialing a range of applications of its patented transdermal drug delivery technology. These include treatments for menopause,sexual dysfunction, nausea and a contraceptive application. All these markets are large, but in most instances patent lives are limited.The technology is validated with product already in market and trials are relatively cheap and of short duration. ACRs Axironproduct, a testosterone supplement for men, is the subject of a high-value licensing deal with Eli Lilly.

The Company posted revenue of $5.1m and PBT of $2.5m in 1H13. Importantly net operating cash flow turned positive - $2.3mcompared with negative $4.5m. Since 30 June 2012 cash reserves fell from $28m to $19m, reflecting an $13.3m dividend payment(8cps). ACR will pay another dividend in August 2013, which is expected to be 16cps. Dividends and capital gains do not attract tax as

Acrux is a Pooled Development Fund (PDF). The Company indicated that Lillys level of rebates to drive sales is falling as a growingnumber of healthcare plans begin to cover the cost of the supplement. This was reflected in net sales of Axiron jumping 49% fromUS$16m in the September 2012 quarter to US$23.9m in the December 2012 quarter, well above market growth of around 8%.

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Sirtex Medical (SRX) market cap $0.6bn (up 2% for month)

SRX has developed an effective treatment for liver cancer that involves the infusion of radioactive microspheres that selectively targetliver tumours. Sales growth has become consistently strong despite the treatment still being used chiefly as a last resort. Large scaletrials in progress should significantly promote use. Gross margins are in excess of 80%. Risks include weak intellectual propertyprotection, SRXs limited resources, and single product portfolio along with the more generic risk of obsolescence.

The Company delivered a very solid first half result. A 31% surge in dose sales drove revenue 25% higher to $46m. NPAT rose 28% to

$7.8m. Net operating cash flow increased 132% to $13.2m. There is no interim dividend. A 10 cent dividend was paid in October 2012,43% above the 7 cent dividend in 2011. At the end of December 2012 SRX had net cash of $51m, up $10m on pcp and representingalmost a dollar per share. The Company continues to look for worthwhile investments including additional product to sell via itsestablished distribution network.

Health Care Equipment & Services Sector News

ResMed (RMD) market cap $6.8bn (up 2% for month)

Sleep apnoea is a huge medical problem that can go unnoticed and untreated. RMD is helping lead the charge on sleep apnoea andshould benefit from strong growth for the long run by serving this huge potential marketplace. If the Company continues to up theinnovation ante with new product introductions, including new airflow generators, masks and nasal pillows, it should remain aninfluential leader in this market for the foreseeable future. Operating margins are impressive, typically exceeding 20%. In 2012 RMD

began paying dividends. The balance sheet has net cash. We think growth-oriented investors should consider buying shares of thisnarrow moat firm at a reasonable price.

We undertake a closer look following the release of the results of round two of the US Government medical insurance (CMS)competitive tender process for supply of durable medical equipment. Around 35% of sleep disordered breathing equipment sales arecovered by CMS. We understand this equates to 25% of RMDs sales in the Americas segment, which make up a little over 50% ofits global sales. Instead of the 30% falls seen in round one, the price decreases were significantly greater at 45 50% in round two.Our revenue forecasts already factored in a view that strained public and private finances in the developed world would constrainfuture growth. Competitive tender is one method of reducing spending. Given the extent of the price falls we have reduced ourforecasts for the Companys US revenue growth from 12% to 10% in fiscal 2014 and from 10% to 8% in fiscal 2016 when round threeof the tender process is likely to hit. Our calculation assumes RMD absorbs roughly one third of the 45 50% price falls, the dealersbearing the remainder. These changed assumptions result in the operating margin falling from 24% to 23% in 2017 and net income

falling by around 5% by fiscal 2017.

Ramsay Health Care (RHC) market cap $6.5bn (up 1% for month)

RHC is a premier private hospital operator generating industry-leading margins. Strong cashflow from the portfolio of qualityhospitals is invested to enhance facilities. It has over 117 hospitals and day care facilities, 30,000 staff, manages over 10,000 bedsand has annual revenue of over $3bn. The Company operates a decentralised control structure to empower operators. Many of thehospitals present natural monopolies for their region because of location, scale and reputation. Offshore expansion provides anotherleg of growth as RHC exports its business practices.

In March 2013, the Company confirmed speculation it has entered into a 50:50 joint venture with Malaysian conglomerate SimeDarby Berhad (Sime) to expand its healthcare businesses in Southeast Asia initially and eventually throughout Asia. The deal combinesthe RHCs three hospitals in Indonesia with Simes portfolio of healthcare assets in Malaysia, which include three hospitals and a

nursing and health sciences college. The joint venture aims to assemble a portfolio of hospitals throughout Asia to benefit fromAsias rising middle class and ageing population. Simes financial strength and business networks through South-East Asia shouldbe a potent complement to Ramsays hospital management expertise. However, we note that RHC will continue to generate themajority of earnings roughly 75% - from its Australian business, the next biggest regional contribution coming from UK operationsat near 18%. The Asian initiative is unlikely to become meaningful for several years at least.

Sonic Healthcare (SHL) market cap $5.5bn (up 4% for month)

Technological innovation has cut the cost of a general pathology test, translating into bigger profit margins. SHL leverages thisknow-how in overseas markets to deliver the next stage of growth. The US, Germany and UK offer scope to deliver efficiencythrough acquisitions, and international scale will further enhance buying power. The federation business model aims to empower itsoperators to focus on revenues while SHL consolidates back office processing.

The Companys Australian operations posted 5% organic revenue growth, in line with estimates of industry growth. There was a 1.1%fall in pathology fees from 1 January 2013 as the government seeks to offset growth above the 5% cap. In Germany, where SHL is oneof the two largest players, it reported solid 5% organic revenue growth, and 8% growth including revenue from acquisitions. TheCompanys two non-pathology divisions Sonic Imaging (radiology), and IPN (medical centres) both delivered solid performances


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Continued page 20

and together generated around 20% of group revenues. The radiology division grew revenue 6%, while IPN grew revenue 15%. Bothenjoyed strong margin expansion. SHL disappointingly lowered full-year guidance and now expects EBITDA to be at the lower endof guidance released in August 2012 for 5 10% growth. Key reasons for the lower guidance are larger than expected unfavourableindustry funding changes in Germany, unexpected anatomical pathology fee cuts in the US ($6m pa), and lower than expectedgrowth in the US (revenue fell 2%) including the impact of Superstorm Sandy.

Cochlear (COH) market cap $3.9bn (down 4% for month)

COHs implantable device is the gold standard for enabling profoundly hearing impaired patients to hear. The Company is aninnovative leader in not overly competitive and growing markets. Growth stems from further penetration of existing markets andentry into undeveloped markets such as South America, Eastern Europe and China. Acquisition of Entific extends the presence to thelarger partially-impaired market. COH invests 12% of sales in research and development to remain at the technology forefront. Thisis a strong cash generator with impressive operating margins around 30% and modest capital expenditure requirements.

First half fiscal 2013 revenue at $392m was 1% higher than pcp. Excluding the negative $130m impact of the product recall on pcpprofit, EBIT fell marginally to $108m while NPAT fell 3% to $78m. The stronger AUD had a negative impact of $21m on the bottomline. The EBIT margin was little changed at 28.5%, a good achievement given the stronger AUD. Earnings per share weakened 3% to$1.36. The Board raised the dividend 4% from $1.20 to $1.25 per share. Franking is 40%, down from 60% in the pcp. The result wasbelow market expectations. Unit sales of cochlear implants (80% of revenue) rose 27% but resulted in only a 6% increase in dollarsales to $330m. In constant-currency sales rose 10%. The lesser revenue growth reflects both low-priced government tender sales

into China and distortion due to the product recall. A more telling statistic is that units grew 11% on a sequential half basis suggestingthe Company is holding market share.

Primary Health Care (PRY) market cap $2.5bn (flat for month)

PRY and Sonic Healthcares Independent Practitioner Network (IPN) are leaders in Medical Centre management while its pathologydivision is part of an oligopoly with Sonic Healthcare and Healthscope. These strong industry positions and the non-discretionarynature of medical services imply usually reliable and modestly growing earnings, underpinned by the ageing population. Managingdirector Edmund Bateman is PRYs principal founder and is responsible for delivering phenomenal returns through the developmentof 24-hour medical centres. The acquisition of Symbion Healthcare in 2008 transformed the asset pool. The merged group is thelargest domestic pathology provider. Earnings are: Medical Centres 47%, Pathology 36%, Radiology 12% and Health Technology 5%.

While the Pathology division has caused headaches, the Medical Centre division, which contributes around 45% of group EBITDA,

continues to perform well, posting around 6% EBITDA growth in fiscal 2011, fiscal 2012 and first half fiscal 2013. PRY is addingdoctors to fill existing capacity in centres and does not plan material incremental investment in the division. The smaller Imagingdivision around 20% of group EBITDA is also displaying healthy growth, benefiting in particular from the new fee-for-servicemodel which ties radiologists pay more closely to revenue generation. Investment in equipment and information technology is alsopaying off. Imagings EBITDA jumped 30% to $35m in 1H13. The Company benefitted from a material fall in borrowing costs from$56m to $40m.

Ansell (ANN) market cap $2.1bn (up 2% for month)

ANN is a global leader in protective health and safety protection solutions. Operations spread across four business segments coveringindustrial and medical gloves, and condoms. Products are predominantly made of natural and synthetic latex, exposing ANN to pricefluctuations in rubber and latex concentrates. Low levels of debt offer prospects for further capital initiatives or acquisitions. Nofranking credits means free cashflow is distributed predominantly through share buybacks.

First half fiscal 2013 NPAT fell well short of market expectations. This was a function of softening demand in Europe and to a lesserextent in emerging markets. Organic sales were flat despite management expectations for mid single-digit growth. Total sales rose6% to US$648m, but EBIT fell 8% to US$69m. NPAT and EPS fell 14% to US$57m and US$0.42 respectively. Gross margin weakenedslightly to 41.3%, but materially higher marketing costs caused the EBIT margin to fall from 12.2% to 10.5%. Indicating its confidencein a better outlook for the second half, the Board increased the interim dividend 1 cent to 16.0cps, unfranked.

Fisher & Paykel Healthcare (FPH) market cap $1.1bn (up 1% for month)

FPH is the worlds leading provider of Respiratory Humidification (RH) products and commands a high market share. It also producesCPAP and masks for treatment of Obstructive Sleep Apnea (OSA). The Company has unveiled a slew of new products and interfacesin respiratory and sleep apnea which should boost revenue and earnings over the long term. North America is a key growth area forFPH and a critical market for Obstructive Sleep Apnea (OSA). Earnings are sensitive to the NZ$/US$ exchange rate.


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FPH raised its earnings guidance from NZ$69-72m to NZ$75m, mainly due to strong trading in the second half so far. Sales growthwas particularly impressive for the firms respiratory and acute care (RAC) business which is likely to achieve constant-currency revenuegrowth of 18%. In the first half RAC grew by 11%. Obstructive Sleep Apnea (OSA) is also likely to see a lift in constant-currency growth from3% in the first half to 10% in the second half but the second half growth is below our forecast of 13%. FPH also expects an improvementin operating margins as a result of new products, operating efficiency gains and cost savings from the Mexican manufacturing plant.

Sigma Pharmaceuticals (SIP) market cap $0.9bn (up 12% for month)

SIP is one of Australias three pharmaceutical wholesalers. Earlier in its history it impressed on a number of fronts and successfullygrew both organically and by acquisition. In late 2005, it merged with Arrow Pharmaceuticals, a rapidly growing generics player,which proved an expensive exercise after profitability in the generics sector plummeted. In late 2010, SIP sold its manufacturing andgenerics business to Aspen Pharmacare, allowing it to reduce debt.

SIPs fiscal 2013 underlying result of $52m was broadly in line with expectations. New management has stabilised the business in theface of Pharmaceutical Benefit Scheme (PBS) price reforms and we expect the severity of such reforms to moderate. Operationalefficiencies and expanding retail brand membership will support modest earnings growth. With $83m net cash on the balance sheet,capital position is healthy. The continued share buy-back is positive for investors and combined with a healthy full franked dividendof around 6.7%, provides some share price support.

Key Small Cap Updates

Strong Monthly Performers

Vita Life Sciences (VSC) market cap $79m (up 82% for month)

VSC provided outlook commentary that revenue compound annual growth of 13% over the last three years is expected to continuein 2013 and potentially increase as the New Business Units start to make larger contributions. Over the same period EBIT compoundannual growth has shown an increase of 54% reflecting the gains made in cost control and operating leverage. Barring unforeseencircumstances, Directors are targeting a 40% to 50% increase in EBIT in 2013. The strong cash position, positive cash flows fromoperating activities and being debt free leaves the Company in a strong position to expand its business and take advantage of futuregrowth opportunities as they arise.

Capitol Health (CAJ) market cap $75m (up 30% for month)

CAJ announced the acquisition of MDI Group, a specialist Diagnostic Imaging (DI) company with 11 clinics primarily located in thesouth-eastern regions of the Melbourne metropolitan area. The acquisition is expected to deliver significant financial and strategicbenefits to Capitol and position it as the largest community-based DI provider in Victoria with 48 clinics. The combined Capitol andMDI consolidated group is expected to generate annualised revenues of over $80m and increase EPS by 25% in 2014 (compared to2013). It is expected to deliver higher margins per dollar of revenue earned due to higher rates charged by MDI clinics which operateunder a gap charging model.

Clover Corporation (CLV) market cap $102m (up 22% for month)

CLV reported a 12.5% increase in 1H13 sales to $20.2m from $17.9m in 1H12. Sales of encapsulated ingredients for infant formula andrelated applications continue to grow, particularly in Asia and Oceania. The Company continues to invest in the future with additionalfunding provided for the development of new products including the provision of the preterm infant formula for the current Phase3 clinical study. This trial is on time for the delivery of preliminary results by the end of 2014. In addition the evaluation by customers

of several new products is likely to lead to small initial sales in 2H13. The CLV expects the strong demand for its products to continuefor 2H13.

Mayne Pharma (MYX) market cap $270m (up 22% for month)

MYXs 1H13 result was at the top end of earnings guidance provided in October 2012. Metrics 1.5 month contribution exceededguidance with strong growth in generic products through its own distribution channel and solid growth in contract manufacturing.This helped to offset a 29% decline in revenue from Mayne Pharmas existing business, on the back of lower Doryx sales in the US.The Company indicated that it remains on track to deliver FY13 results in-line with previous guidance and it expects 2H13 to benefitfrom a return to Doryx revenue growth over 1H13.

Greencross (GXL) market cap $169m (up 19% for month)

GXL reported an underlying 1H13 NPAT of $3.5m (up 35%), and EBITDA was $7.8m (up 32%), on revenue of $51.2m (up 30%). Eight

new veterinary practices were acquired, bringing the total to 89 at the end of the half. Acquisitions continue to be the main driver ofgrowth and the Company will continue to target one to two new acquisitions per month. CEO Glen Richards indicated that it wasoperating in a resilient industry with a large client base of non-discretionary spending pet owners and continued to see increasingannualised visits and spend per patient.


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Weak Monthly Performers

Tissue Therapies (TIS) market cap $34m (down 42% for month)

In March 2013, TIS was informed by the Notified Body, British Standards Institute (BSI) that a European Commission (EC) MedicalDevices Group meeting voted that VitroGro ECM should be regulated as a Medicine and not a Device. In October 2012, theCompany was previously notified by BSI that the final classification of VitroGro ECM was as a Device. Until the email from BSIon 13 March 2013, the advice to TIS from BSI was that it was waiting only for a formal start date for the European Medicines Agency

(EMA) Committee review of manufacturing quality data as the last step needed for the granting of CE Mark and the start of sales.

Pharmaxis (PXS) market cap $102m (down 41% for month)

Pharmaxis received a complete response letter from the FDA confirming Bronchitol cannot yet be approved for marketing forthe treatment of cystic fibrosis in the US. The FDA has concluded its review of the Bronchitol New Drug Application (NDA) andrecommended Pharmaxis conduct an additional clinical trial to obtain an approval for Bronchitol. Pharmaxis CEO Gary Phillipscommented We are clearly disappointed that Bronchitol cannot yet be made available to patients in the US. The FDA has providedguidance on the necessary measures to gain approval and Pharmaxis will now have a follow up meeting with the FDA. This will be aType A meeting which I expect will take place next quarter and will examine the parameters of an additional clinical trial includinghow best to incorporate both adult and paediatric patients.

Overview of Contacted Small Caps

Figure 9: Business model, catalysts and risks

Company Business Description Key FocusIP Portfolio and

Key RelationshipsDrivers Risks

Pharmaceuticals & Biotechnology

Antisense Therapeutics Drug developmentcompany focused ondeveloping antisensedrugs.

The Company hassufficient funding wellinto 2014 (including theATL1103 Phase II clinicaltrial) and its technologyplatform was validatedin January 2013 by Isisreceiving FDA approval forthe worlds first antisensedrug administeredsystemically (injected).

ATL1103 targets diseasesassociated with excessiveGrowth Hormone andInsulin Growth Factor-Iaction such as Acromegaly.

ATL1102 is an antisenseinhibitor of VLA-4 protein,a clinically validated targetin MS and potentiallyasthma and stem cellmobilisation.

ATL1101 is an inhibitor ofInsulin Growth Factor-IR,an emerging target inoncology.

Exclusive world-widerights to three compoundsin- licensed from IsisPharmaceuticals Inc, theworld leader in antisensedrug development andcommercialisation.

ANP also has astrategic a lliance withTianjin InternationalJoint Academy ofBiotechnology andMedicine (TJAB) for itsATL1102 studies.

ATL1103: re-ratingfollowing outcome ofPhase II trial.

ATL1102: re-rating onmove into longer termPhase II studies.

ATL1101: progress ofpotential partnering/ development plans.

Clinical progress ortransactions involvingantisense drugs externalto ANP.

General pharmaceuticaloperating risks: long leadtimes and uncertaintyof result outcomes;complex governmenthealth regulations; intensecompetition; loss of keypersonnel; potentialproduct liability; additionalcapital requirements.

Mayne Pharma Specialty pharmaceuticalcompany that developsand manufacturesproprietary and genericproducts.

In November 2012 itacquired Metrics, a US-based provider of contractdevelopment servicesto the pharma industry

which also developsand manufactures nichegeneric products.

The combined grouphas a significant productportfolio and pipeline,global reach throughdistribution partners inAustralia, US, Europe andAsia and manufacturingfacilities located in SouthAustralia and NorthCarolina (US). Pipeline

of 17 products underdevelopment post Metricsacquisition.

The Company has a30-year track recordof innovation with itsintellectual propertyportfolio built around theoptimisation and deliveryof oral dosage form drugs.

Meeting FY13 guidancefollowing acquisition ofMetrics.

SUBACAP approval inEurope.

Relaunch of Kapanol inAustralia.

FDA approval of Doryx.

General pharmaceuticaloperating risks: long leadtimes and uncertaintyof result outcomes;complex governmenthealth regulations; intensecompetition; loss of keypersonnel; potentialproduct liability; additionalcapital requirements.

Health Care Equipment & Services

Capitol Health Through organic growthand acqusitions, CAJhas become Victoriaslargest community-baseddiagnostic imagingprovider with 48 clinics.CAJ operates clinics andassociated practices acrossMelbourne and regionalVictoria and offers afull range of procedures

ranging from basix X-raysthrough to NuclearImaging.

The Company was focus

monthly strategic outlook april 2013

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