The benchmark S&P/Australian Securities Exchange 200 Index posted a gain of 2.5 percent from April 8 through April 12, its first weekly gain in the last five and the best five-day showing in the last nine months.

The S&P 500 Index, meanwhile, made new all-time record highs this week.

Day-to-day and week-to-week moves in major indexes can be fleeting. The composition of the S&P 500’s recent surge to record highs, in fact, has confounded longtime observers who wonder about a rally that appears to be powered by health care, utilities and consumer staples stocks, sectors that usually do well as investors react to fear of an economic slowdown, at the same time that consumer discretionary stocks are hitting new highs as well.

The latter, according to researchers at Merrill Lynch, “is a bullish back-drop for the sector and for the US equity market longer-term.”

And can’t rising health care, utilities and consumer staples stocks be explained by factors such as investors responding to an aging population’s needs as well as a desire for higher yields at a time when the yield on the 10-year US Treasury is around 1.75 percent?

These are complex forecasts and questions, the truth and answers to which will only be borne out over more time. Our focus remains on buying and holding high-quality companies that demonstrate consistently the ability to build wealth. We stick with those that show durability through the cycle, while we move from those that demonstrate otherwise as soon as the evidence changes.

Meanwhile, changes of a not-quite-glacial but certainly larger-scale nature than the temporal vicissitudes captured by stock indexes and trumped up by financial television carnival-barkers continue to unfold.

Topping the list for present purposes are two developments with the Australian dollar.

As we note in this month’s News & Notes column, Australian Prime Minister Julia Gillard announced on April 8, 2013, an agreement that will allow the Australian dollar to be traded directly with the Chinese yuan.

The aussie is the third major currency to have direct trading with the yuan, following the US dollar and the Japanese yen.

The currency deal will lower transaction costs for Australian companies doing business in China.  No longer will they have to convert their finances into US dollars and then into Chinese yuan, which is also known as the renminbi.

And as we reported in the April 4 Down Under Digest, the aussie is moving into a higher-rent neighborhood: The Australian dollar, along with the Canadian dollar, will be broken out from the group of currencies reported as “other” in the International Monetary Fund’s (IMF) Composition of Foreign Exchange Reserves (COFER) database.

“The IMF is expanding the list of currencies separately identified in the COFER template,” an IMF spokeswoman told the Wall Street Journal. “The implementation of the revised COFER Report Form, with separate identification of the Australian dollar and Canadian dollar, is scheduled for the first half of 2013.”

The March 29, 2013, COFER report showed that the share of central bank reserves tied up in dollars and yen declined during the fourth quarter of 2012, while the share devoted to the euro was unchanged.

Meanwhile, the share invested in “other”–which included non-traditional currencies such as the aussie and the loonie–surged to an all-time high of 6.12 percent.

In other words, demand from central banks is propping up the aussie, despite a series of cuts that’s taken the RBA’s overnight cash rate from 4.75 percent in October 2011 to 3 percent today.

Forecasters have predicted a slide below parity with the US dollar as Australia’s non-mining sectors struggle. Although the aussie has dipped below USD1.02 in recent weeks it’s consistently bounced back. This suggests central banks are stepping in on weakness, providing a floor for the currency.

The “big five” still command the lion’s share of central bank foreign currency holdings. But the trend toward the aussie and the loonie–which share in common underlying economies focused on resource production and export as well as supporting governments with relatively low levels of debt–is clear.

“Other” surpassed the Japanese yen to take fourth place during the fourth quarter of 2009 and leapt over the British pound for third place in the third quarter of 2010.

The US dollar and the euro remain in first and second place, respectively, but “other’s” share has grown substantially in the 21st century, from 1.49 percent of allocated reserves at the end of 2000 to 5.49 percent in 2011 to the present accounting above 6 percent as of Dec. 31, 2012.

It’s important to note that the IMF is simply breaking out data for the aussie and the loonie. This alone should have no substantive impact, as it’s an after-the-fact accounting of actions central banks have already taken.

A new line-item doesn’t make these currencies any more or less fundamentally attractive. But it does acknowledge the fact that the Australian dollar and the Canadian dollar have achieved a certain critical point in the eyes of central banks around the world.

It’s also cause to reflect on what we’re doing in Australia, and that’s buying and holding solid businesses that will grow along with an economy that’s maturing into new level of significance, due in large part to its burgeoning relationship with China, on the world stage.

Portfolio Update

Since the first issue of Australian Edge in September 2011, we’ve been in a portfolio-building process. Starting with our original “Eight Income Wonders from Down Under,” we’ve steadily added bargains as they’ve appeared to create the current well-balanced lineup.

Several Holdings have surged enough for us to advise readers take a partial profit. But for the most part, it’s been buy and hold. And as the table “Technical Profile” shows, the results have been mainly positive.

The notable exceptions to the rule were the relatively short Portfolio tenures of Aggressive Holdings Iluka Resources Ltd (ASX: ILU, OTC: ILKAF, ADR: ILKAY) and Grange Resources Ltd (ASX: GRR, OTC: GRLLF).

Iluka was first recommended in March 2012. But by July it was clear the world’s largest producer of zircon would be confronting major market headwinds, and we were out. As it’s turned out, Iluka now expects to produce just half the zircon, rutile and synthetic rutile in 2013 that it did in 2012.

We replaced Iluka with Grange in July. By September, however, that company too had faltered, as prices of the iron ore and gold it produces began to back off, and smaller mining companies suffered disproportionately.

We took losses on both stocks. But by selling Grange we avoided taking a much larger hit, as small mining companies in general have continued to weaken. As for Iluka, it’s been range bound. But with zircon still soft it’s hard to see a catalyst for recovery anytime soon.

Selling was the right move for both positions. And, unfortunately, that now appears to be the case for one of our original “Income Wonders from Down Under,” New Hope Corp Ltd (ASX: NHC, OTC: NHPEF).

Portfolio Update has more on New Hope as well as the latest noteworthy developments among current Holdings.

In Focus

The first of 2013 was a fair-to-middling quarter for the AE Portfolio, at least if you’re comparing to major measures of equity performance such as the S&P/Australian Securities Exchange 200 Index, the S&P 500 Index and the MSCI World Index.

The main Australian benchmark, the S&P/ASX 200, generated a total return in US dollar terms during the first three months of the year of 8.47 percent. The S&P 500–the most widely benchmarked equity index in the world–was up 10.61 percent, while the MSCI World Index was up 7.87 percent.

The Australian dollar began 2013 at USD1.0394, sank as low as USD1.0196 on March 4 and surged to USD1.0419 by the end of March, providing a very slight uplift for US investors’ capital gains and dividends. As of this writing the aussie is at USD1.0503.

The 26 current members of the AE Portfolio, meanwhile, generated an average return of 6.39 percent, lagging even the broader AE How They Rate coverage universe, whose 115 members generated an average US-dollar total return of 6.89 percent.

Breaking it down to its constituent parts, however, reveals somewhat encouraging data. The Conservative Holdings, among which are five of the “Eight Income Wonders from Down Under” that comprised the original AE Portfolio, generated a total return of 9.71 percent, trailing only the S&P 500 among our three benchmarks.

The Aggressive Holdings, half of which hail from the Basic Materials sector, the biggest laggard among the 10 designated by S&P and that define our How They Rate groupings, posted a positive return of 2.53 percent.

In Focus details highlights and lowlights for the AE Portfolio for the first three months of the year and takes a sector-by-How-They-Rate-sector look at performance and notable divided news.

Sector Spotlight

AE Portfolio Conservative Holding M2 Telecommunications Group Ltd (ASX: MTU, OTC: MTCZF) reported a 47 percent increase in fiscal 2013 first-half net profit after tax to AUD24.7 million, a surge largely attributable to the online and mobile phone service provider’s June 2012 acquisition of Primus Telecom Holdings Ltd.

When the Primus deal was first announced, in April 2012, M2 CEO Geoff Horth described it as potentially “transformational,” and that forecast has, at least to this point, proven to be on point. The deal also positioned M2 for the move to a new fiber access regime Down Under, with the broader technical and National Broadband Network (NBN) expertise provided by Primus.

When the NBN launches all telecommunication providers will be required to largely operate as “resellers” of broadband services, which is essentially the business model M2 operates now and clearly well understands.

In mid-March Mr. Horth announced a set of deals that he described as “significant” in terms of the scale it will allow M2 to achieve and “material” in terms of how it will impact shareholders: the AUD203.9 million acquisition of Dodo Australia Holdings Ltd on a debt-free and cash-free basis and the off-market takeover offer for Eftel Ltd at AUD0.3581 per share in cash or shares, implying a total enterprise value of AUD44.1 million, including AUD5.6 million of net debt.

Management expects the acquisitions to contribute in excess of AUD400 million of revenue and AUD50 million of earnings before interest, taxation, depreciation and amortization (EBITDA) in fiscal 2014.

Based on a median broker fiscal 2014 earnings per share (EPS) estimate of AUD0.41 for M2 and assuming the acquisitions contribute in excess of AUD50 million of EBITDA, Dodo and Eftel are expected to result in underlying fiscal 2014 EPS accretion of approximately 20 percent.

The move is also likely to fuel longer-term dividend growth for M2 following the company’s 15.3 percent boost to its fiscal 2013 interim payout.

For more on M2 Telecommunications, see the first of April’s Sector Spotlights.

During the past 85 days AE Portfolio Aggressive Holding Rio Tinto Ltd (ASX: RIO, NYSE: RIO) has fired its CEO, booked a USD14 billion writedown on its assets and reported a USD2.99 billion annual loss for 2012.

The initial market reaction to the first two of these developments–which actually took place on Jan. 17, 2013–was positive, as Rio stock surged from a close of AUD64.60 on the Australian Securities Exchange (ASX) on the fateful day to a 2013 closing high of AUD72.07 on Feb. 14.

Feb. 14 was the day Rio reported results for 2012, and since then the stock has sunk as low as AUD54.60 on April 4–a 24.2 percent top-to-bottom slide–and now trades just north of AUD58. That’s 10.3 times estimated 2013 earnings.

Rio has now written down USD28 billion of the USD38 billion it paid for aluminum producer Alcan in 2007.

But as the reaction from Jan. 17 through Feb. 14 indicated, the market appreciated the recognition of past strategic overreach. What’s weighed on the share price since the 2012 earnings announcement is a combination of factors, including fears of lower iron ore prices and a potential near-term surplus in copper. There’s also the lingering threat of a slowdown in China’s property sector.

Investors are also focused on the potential impact on dividend growth and other capital management initiatives such as share buybacks of high capital expenditures on new projects that may help only to drive commodity prices lower. Potential surpluses of iron ore, chiefly, could drag on earnings-per-share growth.

At the same time, however, these potential downside catalysts are already priced into Rio stock, and overlooked are several factors that support not only the current valuation but provide a basis for upside as well.

For more on Rio Tinto, see the second of this month’s Sector Spotlights.

News & Notes

The Aussie and the Yuan: As of this week the Australian dollar is the third major currency to be traded directly with the Chinese yuan, joining the US dollar and the Japanese yen.

Interest Rates, Commodity Prices and China: Reserve Bank of Australia (RBA) Governor Glenn Stevens, noting that “a number of indications that the substantial easing of monetary policy during late 2011 and 2012 is having an expansionary effect on the economy,” kept Australia’s cash rate at 3 percent following the central bank’s April 2 monetary policy meeting.

Meanwhile, the RBA’s preliminary estimate for its Index of Commodity Prices for March indicates a 0.2 percent increase in Special Drawing Rights (SDR) terms. The index was up a revised 2.6 percent in February.

And China’s official purchasing managers’ index rose to 50.9 in March from 50.1 in February, while the HSBC PMI, which is weighted toward small and medium-sized companies as opposed to the larger, state-owned entities that generally comprise the government survey, rose to 51.6 in March from 50.4 in February.

The Dividend Watch List: The Dividend Watch List includes updates on How They Rate companies that announced dividend cuts during fiscal 2013 first-half earnings reporting season Down Under as well as those that reduced earnings guidance in recent weeks. It also includes those that cut payouts during their most recent reporting period but that don’t report based on a July 1-to-June 30 fiscal year or a calendar-year basis.

The ADR List: Many Australia-based companies that list on the home Australian Securities Exchange (ASX) are also listed on the New York Stock Exchange (NYSE) or over-the-counter markets as “sponsored” or “unsponsored” American Depositary Receipts (ADR).

Here’s a list of those companies, along with an explanation of what these ADRs represent.

How They Rate

How They Rate includes 111 individual companies and four funds organized according to the following sectors/industries:

• Basic Materials
• Consumer Goods
• Consumer Services
• Financials, including A-REITs
• Health Care
• Industrials
• Oil & Gas
• Technology
• Telecommunications
• Utilities
• Funds

We provide updated commentary with every issue, financial data upon release by the company, and dividend dates of interest on a regular basis. The AE Safety Rating is based on financial criteria that impact the ability to sustain and grow dividends, including the amount of cash payable to shareholders relative to funds set aside to grow the business. We also consider the impact of companies’ debt burdens on their ability to fund dividends. And certain sectors and/or industries are more suited to paying dividends over the long term than others; we acknowledge this in the AE Safety Rating System as well. We update buy-under targets as warranted by operational developments and dividend growth.

In Closing

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David Dittman
Co-Editor, Australian Edge

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