Also in this issue
8 Stocks for an uncertain market
18
The
Gold
Rush
19 Global Megatrends
26 Inflation – the invisible enemy
32 Market Summaries
research
News & Views
Issue 2, September 2011
Portfolio
Strategy Briefing
Strategies for boosting income, accessing growth
and reducing risk in uncertain times
research
News & Views
Issue 2, September 2011
Cameron Watson
Director, Private Wealth Research
Michelle Perkins
Senior Research Analyst
Mark Lister
Head of Research
Prices as at 24 August 2011 unless otherwise stated.
Craigs Investment Partners
Special Topic
19 Imbed a ‘Global Megatrend’ in your Portfolio Seven long-term ‘global megatrends’ and a selection of global stocks that are well placed to benefit
Currency
23 Where Dow go, NZD shall follow
We might favour NZ Dollars, but we should also buy some US Dollars as a counterbalance to the New Zealand/Australian bias in our portfolios
Fixed
Income
24 Add some credit risk for yield, but keep the bedrock safe
Tackle the challenge of low interest rates by keeping fixed income portfolios safe and structured, but add some credit risk for extra yield
Investing Perspectives
26 Inflation – The invisible enemy Why 100% cash only feels safe 27 It’s a Simple Problem…
There are but five investments, and silver bullets aren’t one of them
28 Excerpts
Interesting anecdotes and quotes from the world of finance
29 It doesn’t take much
Very small changes to share valuation inputs can make a big difference
Summary Data
30 Sector Summary 32 Market SummariesLeaders
2 Balanced PortfoliosHow to build a defensive balanced portfolio 4 Debt Debacle: What investors can do
The ongoing sovereign debt problems in Europe and the credit downgrade of the United States point to an extended period of lower economic growth and a period of volatility, but opportunity for investors
Portfolio Strategy
6 First things first: Re-check Asset Allocations
Our sample portfolio allocations for differing risk profiles 7 Tactical Asset Allocation: Home comforts
Follow the cash - Bias portfolios towards countries like NZ, that have low debt, companies with solid dividends, and defensive fixed income
Equities
8 Stocks for an uncertain market: Buy More of Less Add to weightings in core Trans-Tasman stocks 11 Take a value approach when buying Emerging
Markets directly
Managers with a value orientation add a margin of safety to investing in Emerging Markets
13 Old-World defensiveness, New-World growth Get the best of all worlds by accessing Emerging Markets through Global Leaders
14 Consider Contrarian Investments
An allocation to non-conventional stocks can provide a portfolio with some ballast during market falls
15 Low interest rates may attract buyers to high income stocks
Add some high yield stocks to boost income. These stocks could also see increased buying pressure from investors seeking to replace interest income
16 Give your portfolio a Spring Clean
Review underperforming or high risk stocks, some better options may be available
17 The Magic of Midcaps
We believe Midcaps have a ‘sweet-spot’ that produces higher returns – they are big enough to survive, yet small enough to grow
18 The Gold Rush
The unprintable currency is in hot demand. Portfolios should have some exposure to gold
Balanced Portfolios
How to build a defensive balanced portfolio
Leaders
The recent period of intense volatility in financial markets serves only to underline the importance of controlling risk in portfolios as much as possible, and certainly to a level that remains within each client’s personal tolerance for risk.
While we all want to seek the potential returns available from equities, the asset class that offers
the highest returns, there is a price to pay for this upside – risk. The past month is a graphic example of how volatile equity markets can be. The only answer for anyone not interested in exposing all of their capital to this sort of volatility is to put together a Balanced Portfolio.
Portfolios should, where possible, be invested directly into markets and hold direct equities and fixed income. This gives you greater control over risk, income and diversification.
In our view, a Balanced Portfolio should have layers of ‘themes’ and ‘strategies’ in it that have the potential to reduce risk and/or boost returns. In many ways it is similar to how we protect ourselves from cold weather by putting on extra layers of clothing - something many of us have become well versed at over recent days in the face of the freezing weather that has
hit the country as I write this. This News & Views profiles a series of our current strategies that we believe should be considered incorporating into your Balanced Portfolio namely:
1) First things first: Re-check your asset allocation to
make sure you have enough in each of the main assets; cash, fixed income, property and equities. Concentrate especially on the split between income assets (cash and fixed income) and growth assets (property and shares). It The best investment is not cash, gold, a
rental property, equities, art or any other single asset. The best investment is a Balanced Portfolio.
“In Scotland, there is no such thing as bad
weather - only the wrong clothes.”
Billy Connolly
The Path of Least Resistance - A Balanced Portfolio gets a slice of the upside but avoids the worst of the downside
Relative Return From Key Investment Assets (NZD) - September 1998 – July 2011
Sep-98 Sep-98 Sep-00 Sep-01 Sep-02 Sep-98 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Jul-11
500 1000 1500 2000 2500 3000 3500 4000
Note: The NZSX All Gross Index is a gross index and from1 October 2005 assumes the reinvestment of cash dividends. Prior to this date, the NZX gross indices assumed the reinvestmentof gross dividends (ie including imputation credits). The Australian All Ords Index is an accumulation (or gross) index and assumes the reinvestment of cash dividends. The MSCI World Gross Index is a gross index and assumes the reinvestment of cash dividends (ie it does not include tax credits). The NZ house price return shown above does not include any income that may have been derived from owning such property. It is purely a measure of capital return. The Wholesale Interest Rate return is after tax (now 30%).
Inflation2 .53%pa
World Share Prices 0.24%pa Wholesale Interest Rates (90 day) 4.12%pa NZ House Prices 5.97%pa Craigs Balanced Portfolio 7.45%pa NZSX All Gross Index
8.61%pa
Australian All Ords 9.03%pa The path of least resistance A Balanced Portfolio gets a slice of the upside but avoids the worst of the downside
is this mix that sets the tone of your portfolio and its risk profile. Check the historical risk and return characteristics of our Sample Asset Allocations on page 6.
2) Tilt your portfolio’s asset allocation to be more defensive. We recommend having more than usual in
cash and also in New Zealand equities where dividends remain attractive. We are loathe to chase long bonds when yields are so low and recommend having less invested in bonds than usual. See our Tactical Asset Allocation recommendations on page 7.
3) Keep cash on hand to take advantage of any market
weakness to accumulate core stocks.
4) Include some offsetting positions in your portfolio.
Combine investments that tend to move in opposite directions. One strategy we recommend at present is to buy some of those unloved US Dollars as an offset to the natural bias in our portfolios to New Zealand and the Asian growth theme. See page 23.
5) In fixed income, add some credit risk to boost yields, but
keep portfolios biased to shorter term securities overall, and ensure portfolios remain structured and anchored in high quality securities. See page 24.
6) In equities, zero in on core stocks that offer what we call a ‘safety trifecta’ of Quality, Income and
Defensiveness. Favour our local (New Zealand and Australian) stocks that we know best. Add to current weightings in core favourites rather than looking around for other names to add. This can dilute the quality of your portfolio. We believe it is more prudent to own more of the best names, even if this means having some overweight positions. See page 8.
7) Include Emerging Markets in portfolios, but do it in a
lower risk way by buying global leaders that source a rising proportion of their revenues from these markets. By doing this you get access to the growth these markets offer while also getting the defensiveness and dividend yields offered by global leaders. We also recommend some direct exposure, but through value-orientated funds. See pages 11 and 13.
8) Consider adding some ‘contrarian’ stocks to your
portfolio. We profile a selection of absolute return and ‘alternative’ funds that have the potential to rise, or at least hold their own when markets fall. See page 14.
9) Buy some high income stocks. While many offer
high yields because they face elevated risks, they may also attract continued buying demand as investors seek income. See page 15.
10) Review every stock in your portfolio and replace high
risk stocks with others that are more defensive and higher quality. We review a selection of core stocks that could require attention on page 16.
11) Buy some Mid-Caps. Mid-Caps have trounced
Large-Caps in the US over the long term. See page 17.
12) Buy some gold. At the current level, upside looks more
limited, but every portfolio should have a modest exposure to gold, either via a gold ETF or buy owning a gold mining company. See page 18.
13) Take a long term view and imbed a ‘Megatrend’ in
your portfolio. We discuss seven long-duration global themes and stocks that stand to benefit on page 19.
Returns as at 31 July 2011
NZD Terms Local Currency Terms 3 Mth Ret % 1 Yr Ret %pa 3 Yr Ret %pa 3 Mth Ret % 1 Yr Ret %pa 3 Yr Ret %pa
NZ Property Shares: NZX Property Gross 4.7 20.0 4.7 4.7 20.0 4.7
NZ Fixed Interest: NZ Govt Bond Index 2.7 6.8 8.0 2.7 6.8 8.0
NZ Investment Grade Bonds: NZX Corp Investment Grade Index 1.6 7.3 8.9 1.6 7.3 8.9
NZ Cash: NZ 90 Day Bank Bills Index 0.6 3.0 3.8 0.6 3.0 3.8
Japanese Shares: Nikkei Index -2.8 -4.2 -4.8 -0.2 3.1 -9.8
NZ Shares: NZX50 Gross Index -3.5 11.9 0.6 -3.5 11.9 0.6
Emerging Market Shares: MSCI Emg Markets Free Gross -11.9 -2.7 -0.4 -4.4 17.8 5.7
World Shares: MSCI World Gross -12.7 -1.6 -4.6 -5.2 19.2 1.3
US Shares: S&P 500 Index -12.7 -3.1 -5.2 -5.2 17.3 0.7
UK Shares: FTSE 100 Index -13.3 -4.4 -9.4 -4.2 10.6 2.4
Australian Shares: Australian All Accumulation Index -14.5 4.4 -0.4 -7.5 4.0 0.4
Debt Debacle: What investors can do
The ongoing sovereign debt problems in Europe and the credit downgrade of
the United States point to an extended period of lower economic growth and
a period of volatility, but opportunity for investors.
Leaders
Markets have been exceptionally volatile over recent weeks as investors have focused on high debt levels in Europe and the United States. While an agreement to raise the US debt ceiling eventually came, the damage was already done to America’s political credibility. Investors reacted badly and markets sold down sharply. Standard & Poors (S&P) downgraded the United States one notch from AAA to AA+, which is the same credit rating as New Zealand and Belgium.
Ongoing debt problems on both sides of the Atlantic are the key concern for markets.
There is no easy way out of this debt dilemma. We believe governments have no choice but to take whatever steps are necessary to reduce debt and bring spending down to a level that is lower than income. We also believe this crisis will be contained, but the outcome will be lower spending and lower economic activity. GDP growth will be below-average for a number of years as households and governments reduce spending, pay down debt, live within their means and rebuild savings. The current problems are not a new crisis, but rather a hangover of the original 2008 global financial crisis. Debt eventually must be repaid.
New Zealand remains relatively well-positioned
In contrast, the New Zealand economy appears to be gaining some momentum. Both the Rugby World Cup and the Christchurch rebuild will add to economic activity, while the export sector continues to perform well. Domestic GDP rose 0.8% in the first quarter, well above the 0.3% assumed by the Reserve Bank of New Zealand (RBNZ) in June. Following the events abroad, we are now expecting the RBNZ will leave the Official Cash Rate unchanged until next year. This extension of our historically low interest rates should further cushion the domestic economy from the impact of slowing global growth and other international tension.
Income buying may support Equities
With interest rates at historic lows, equities have provided the only real source of yield for income investors. With the RBNZ likely to put its interest rate rising cycle on hold, the yield advantage that equities have is likely to remain in place for some time.
The following chart illustrates the difference between the yield on a portfolio of equities compared with bank deposits at present. A portfolio of equities (50% New Zealand, 30% Australia, 10% listed property and 10% global, using our Core Portfolios) currently generates a gross yield of 5.8%.This compares to six-month bank deposits at 4.2% (RBNZ). Perhaps the key issue for investors in deposits is that they are essentially funding the global economic recovery. When you deduct tax at 30% and inflation at 3.3% (we have taken out the GST impact, which would actually have increased the inflation
figure to 5.3%) from the deposit rate of 4.2%, you are left with a negative return – see the bottom line on the chart below.
While the current situation is clearly serious, media reportage is often alarmist and inaccurate. Investing in shares does require a certain degree of tolerance for risk and also a long-term view. Markets so often swing between excessive exuberance and excessive panic. Fair value inevitably sits somewhere in between these extremes. In our view, this most recent bout of ‘fear’ has pushed share prices below fair value, especially when looked at through the lens of dividend yields relative to historic averages and to the yields available on alternative investments such as fixed income. In our view, over the longer-term, share prices should recover recent losses.
Portfolio strategy – What investors can do to protect themselves from this Debt Debacle
1. This volatility may continue for some months as sentiment wavers between on’ and ‘risk-off’. Review asset allocations to ensure you are comfortable with your portfolio’s exposure to growth assets.
2. Invest for income. If your share investments continue to generate good and sustainable dividend yields they should be maintained. 3. Keep cash on hand to take advantage of any
market weakness to accumulate core stocks. 4. Cool heads required. You may have noticed the
media using very emotive and overly dramatic language to describe the current situation across markets. One recent news item about the fall in equity markets managed to insert the words ‘mayhem’, ‘fallout’, ‘nosediving’, ‘tailspin’, ‘battering’, ‘hit’, ‘hammered’, ‘hammering’, ‘plummeting’, ‘shockwaves’ and ‘panic’ into their 30 second introduction.
Equity dividend yields retain income advantage
Source: Craigs Investment Partners estimates, RBNZ
0 2 -2 4 6 8 10
6-mth TDs Equities Real interest rate (6mth TDs)
May 04 Annual returns (% ) Se p 04 Ja n 05 May 05 Se p 05 Ja n 06 May 06 Se p 06 Ja n 07 May 07 Se p 07 Ja n 08 May 08 Se p 08 Ja n 09 May 09 Se p 09 J an 10 May 10 S ep 10 J an 11 May 11
Dividend yield from equities: 5.8% 6mth bank term
deposit 4.2%
Real return from term deposit (after tax and inflation) -0.4%
Back to Dividends
Bouts of market volatility remind us why we like dividends so much. Dividends are much more stable than share prices, and focusing on dividend paying stocks gives us the reassurance that even if share prices are moving up and down, we should still receive our dividends.
The following chart and table show how this can work. We have shown the dividends and capital growth of a $10,000 portfolio evenly spread across six of our favoured dividend-growth stocks. The chart illustrates that annual dividends have grown steadily, despite the portfolio value being volatile at times.
Source: Craigs Investment Partners estimates, RBNZ
Consistent dividend growth helps to mitigate share price volatility
Company
Gross dividend
(cents per share) Share price Gross yield
Todays yield on cost Dividend growth per annum Share price return since 2000 2000 2011 2000 Today 2000 Today Auckland Airport 4.3 12.1 $0.61 $2.28 7.1% 5.3% 19.8% 9.9% 259.0% Ebos 18.2 45.7 $3.68 $6.65 4.9% 6.9% 12.4% 8.7% 80.7% Mainfreight 4.1 28.6 $1.80 $9.60 2.3% 3.0% 15.9% 19.4% 450.0% Port of Tauranga 16.4 47.1 $2.58 $9.36 6.4% 5.0% 18.3% 10.1% 259.7% Ryman 1.0 7.2 $0.34 $2.59 3.0% 2.8% 21.2% 19.2% 658.8% TrustPower 8.3 50.8 $1.83 $7.10 4.5% 7.2% 27.8% 18.0% 286.9%
Future proofing income
The sharp fall in deposit rates over 2008 was a major shock for investors who had all their portfolio in short-term deposits. The decline in deposit rates from around 8% to 4% saw many suffering a halving in their income. For retired people this was especially difficult.
In our May News & Views client newsletter we included a chart showing how dramatic the impact of falling interest rates has been on investors. We estimated that in 2008 when deposit rates were 8.2%, an investor wanting income of $60,000 needed to invest $730,000 in six-month deposits. Today, because deposit rates have fallen to 4.2%, and because inflation has risen 10%, an investor now needs $1,570,000 to generate the same real income.
Interest rates will eventually rise again. But that is not the point – they will undoubtedly fall again after that. The lesson from the sharp fall in deposit rates over 2008 is that investors should diversify their sources of income so they are not entirely reliant on the level of short-term interest rates. Two strategies investors can use to ‘future-proof’ their income are to ‘ladder’ their fixed income investments, and to include growth assets like shares and property in their portfolio. Although we term shares and property ‘growth’ investments, they are also excellent sources of income.
The elephant in the room – low interest rates have decimated retirement savings accounts
Source: Craigs Investment Partners
$0 $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 $1,600,000 $1,800,000 2008 2011 Original capital Extra needed because deposit rates have fallen from 8.2% to 4.2%from 2008 to 2011 Extra capital needed to generate an additional $6,000 in income to cover the 10% rise in inflation since 2008
$730,000
$1,570,000
Capital needed to generate a retirement income of $60,000 (without using capital) for an investor with 100% of savings in 6 month deposits.
$-$200 $400 $600 $800 $1,000 $1,200 $1,400 $1,600 $1,800 $2,000 $-$5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000 $45,000 Di vidend Income 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Portfolio value (RHS) Total dividends per annum (LHS)
Po
rtfolio
Va
lu
First things first: Re-check Asset
Allocations
Our sample portfolio allocations for differing risk profiles
We maintain five Sample Strategic Asset Allocations with varying risk and return characteristics which are detailed in the table below. We regard these as the foundation of any portfolio. The mix of assets and the indicative ranges, or variations from these benchmark allocations, provide an important framework within which the portfolio can be invested. After considering each portfolio’s potential returns, yield and risk profile, clients can work with their Adviser to select the asset allocation (which can be modified to suit) that best matches their risk tolerance and income/growth requirements.
After a period of severe volatility like we have just experienced, it can be very helpful to revisit your asset allocation and ensure
it is appropriate. It is the first place to start with any review of your investments as it, more than anything, will determine your portfolio’s risk and return profile. Concentrate on the split between income assets (cash and fixed income) and growth assets (property and shares). How the portfolio is balanced between the low-risk income side of the ledger and growth assets drives risk and return.
Check the indicative returns and risk profile at the bottom of this table. They are our estimates based on historical data, which we have put together to provide an indication of the likely volatility of each portfolio, and its possible returns.
Portfolio Strategy
Income and Growth Allocations and Indicative Ranges
(Income is Cash and Fixed Income, Growth is
Equities and Property) Income Growth Income Growth Income Growth Income Growth Income Growth
Maximum Income/
Minimum Growth Allocation 95% 5% 70% 30% 60% 40% 40% 60% 25% 75%
Benchmark Allocation 75% 25% 55% 45% 40% 60% 25% 75% 10% 90%
Minimum Income/
Maximum Growth Allocation 50% 50% 35% 65% 20% 80% 10% 90% 5% 95%
Sample Strategic Asset Allocations
Capital Preservation Balanced Income Balanced Balanced Growth Capital Growth Sample Asset Allocations
Cash 25% 10% 5% 5% 0%
NZ Fixed Income 50% 45% 35% 20% 10%
NZ Equities 6% 12% 17% 20% 23%
Australian Equities (unhedged) 6% 13% 17% 23% 29% Global Equities (unhedged) 6% 13% 19% 25% 31%
Property 7% 7% 7% 7% 7%
Source: Bloomberg, Craigs Investment Partners
Indicative risk profile (Based on historical performance of underlying indices since 1997)
Observations based on CIP analysis of index data (including dividends and gross of tax) from Sept 1997 to Dec 2010 weighted in line with the allocations for each portfolio Worst 12m return observed in dataset -5.9% -15.5% -21.2% -26.6% -31.4% Best 12m return observed in dataset 14.0% 20.6% 24.9% 29.6% 34.3% Average compound return over period (%pa) 6.6% 6.9% 7.0% 7.1% 7.3% Volatility (standard deviation) of returns 4.9% 8.8% 11.8% 14.7% 17.7% Approx likelihood of negative 12m return 1 year in 15 1 year in 5 1 year in 4 1 year in 3.6 1 year in 3.2
* After-tax returns are based on a tax rate of 30%
Investor Description
Risk tolerance Low tolerance to loss Some risk tolerance Medium risk tolerance Higher tolerance to risk Good risk tolerance Investment horizon 3 years plus 4 years plus 5 years plus 7 years plus 10 years plus Current income requirement Crucial Medium-High Medium Low Low
Indicative Returns
All data here is CIP estimates based on analysis of historical data and current markets. Key inputs are inflation 2%, deposit rates 4.6%, bond yields 5.2% and Equity Market dividend yields Gross forecast yield (pa) 5.4% 5.2% 5.1% 4.8% 4.6% After-tax* forecast yield (pa) 4.2% 4.0% 4.0% 3.9% 3.8% Total forecast gross return (pa) 6.5% to 7.5% 7% to 8% 7.5% to 8.5% 8% to 9% 8.5% to 9.5% Total forecast after-tax* return (pa) 4.5% to 5.5% 5% to 6% 5.5% to 6.5% 6% to 7% 6.5% to 7.5% Implied real return, after tax 2.5% 3.0% 3.5% 4.0% 4.5%
Tactical Asset Allocation
B/mark Current Comment
Cash 5% 11% Overweight
Our weighting to cash (which includes deposits of 12 months or less) is more of a capital preservation strategy during an uncertain period, rather than a strategy for chasing returns. We expect the RBNZ will leave the OCR on hold at its next meeting (September 15) as a result of the turmoil in global markets.
Bonds 35% 23% Underweight
While recent strong domestic data had been suggesting that interest rates were on the way up, concerns in global markets have more than offset the stronger local economy. As a result, interest rate rises have been delayed, rather than cancelled. Eventual rises will reduce the attractiveness of current bond yields and see prices fall. We continue to advocate a focus on quality bonds, with capital preservation most important. While we continue to recommend a laddered diversified portfolio of bonds, we prefer maturities to have a shorter bias, but generally do not favour the mid-part of the curve, so we recommend a split between short-term bank deposits and circa 5 year bonds, the latter to take advantage of the rising yield curve for longer maturities.
Property 7% 6% Underweight
The LPT’s offer a solid outlook. Balance sheets are strong, although earnings and dividend growth, at least for the next two to three years, will be flat to minimal. Yields are attractive relative to deposit interest rates, which will provide some price support. We expect minimal dividend growth, which suggests that share price growth is also limited, although the sector remains a good option for yield focused investors.
Equities 53% 60% Overweight
(NZ 20%, Australia 20%,
Global 20%)
Equities remain our preferred asset class in terms of value, income generation and inflation protection. Even with low interest rates and sub-trend growth, we believe equities can perform well over the medium term. Reasonable yields will provide some support, and the ongoing realisation that interest rates are likely to stay below historical levels should see investors continue to shift their focus to higher return opportunities. We remain biased to the high quality defensive stocks that have sustainable dividend yields, and have recently signalled a preference for Australasian equities over global equities.
Portfolio Strategy
Tactical Asset Allocation: Home comforts
Follow the cash - Bias portfolios towards countries like New Zealand, that have
low debt, companies with solid dividends, and defensive fixed income
Equity exposures - geographic preferences
NZ Positive Attractive dividend yields, boosted by imputation credits. High currency likely to constrain parts of the economy, and interest rate rises are coming, but the outlook is still better than many other countries.
Australia Positive We believe the Australian economy is strong, despite consumer confidence remaining low and the impact of the strong AUD on the non-resources export sector. Having fallen more than most other equity markets, Australia looks reasonable value.
US Neutral We prefer blue chips with global earnings. The economy is weaker than expected, but the market is attractive in NZ Dollar terms, especially for those US stocks that are exporters and benefit from a weaker US Dollar.
UK/Europe Cautious Blue chips remain good value and earnings are global, but the region face faces massive budgetary and structural issues. Further potential for banking sector problems increases the risks for the region.
Japan Cautious The economy faces structural issues and demographic problems, although recent indicators suggest a strong likelihood that the economy will return to positive growth in 3Q 2011. In particular, exports have been in recovery mode in the wake of the production comeback.
Emerging
Markets Neutral Outdoing the developed world in just about every area: stronger balance sheets, stronger GDP outlook and better policy responses. We have a positive view on this sector, but wait for weakness to accumulate positions. We recommend a defensive bias with a solid base in cash and, within equities, favour markets offering solid dividend yields – such as New Zealand and Australia. Rising inflation in China may force the Chinese government to allow greater appreciation on the Yuan. Any such increase would be a positive for New Zealand and Australia as it would enhance the price competitveness of our exports.
Fixed Income
Asset Allocation - deviation versus benchmark Equites - deviation versus benchmark
New Zealand Australia Global 0% 1% 2% 3% 4% 5% +1% +3% +3% Equities Property Cash +6% -12% -1% +7%
Stocks for an uncertain market: Buy
More of Less
Overweight core Trans-Tasman stocks offering a ‘safety trifecta’ of Quality,
Income and Defensiveness
There is no way you can call this rational. In the first 10 trading days of August, the daily change in the Dow Jones was: -1.0%, -2.0%, +0.2%, -4.3%, +0.5%, -5.6%, +4.0%, -4.6%,
+3.9%, +1.1%. Such wild swings have little to do with the underlying operations of the individual companies on the market, and a lot to do with fear about the global situation. We believe the best way to
navigate this inherent volatility is to buy stocks that are less susceptible to market ructions – those that have a ‘safety trifecta’ of quality, income and
defensiveness. Here we profile our favoured such stocks from New Zealand and Australia. Many of these will be familiar to clients, and many will already own them. Our advice is to own more of them. In such a risk-averse world, why go past the best stocks?
Of course we need to keep portfolios well diversified, but we believe it is sensible to overweight the best stocks – those that are large, liquid, have high-quality businesses, good growth potential, robust balance sheets and, of course, provide a solid dividend, like those profiled here (ranked in order of preference).
Port of Tauranga (POT) - POT's extensive landbank, operational
efficiency, excellent transport (road & rail) connections, balance sheet strength and management expertise provide significant capacity for future growth. POT is a solid long term investment story and, being the country’s largest export port, provides indirect exposure to New Zealand’s terms of trade.
Ryman Healthcare (RYM) - Exceptional quality, a core holding in the aged care sector. Well placed for the ageing demographic in New Zealand and Australia. Existing sites still have capacity and new sites provide solid pipeline of growth. Expanding into Australia and has increased its build rate from 450 to 550 units and beds a year to meet rising demand for its services.
Auckland International Airport (AIA) – One of New Zealand’s
premium assets, and our country’s key contact point with the world. The mix of Aeronautical and property income gives AIA a very defensive earnings profile. After a period of intense capital expenditure in previous years, the airport is all set to handle higher numbers of passengers. This gives the company strong operating leverage as passenger numbers recover off the cyclical low we have seen recently. There has also been a step up in property development initiatives recently.
New Zealand
Equities
Mainfreight (MFT) – One of the best performing stocks on
the New Zealand market over the past decade. The company has cemented its local market position and has expanded its operations around the world. Its US business has reached break-even while the European acquisition (Wim Bosman) appears to be a game-changer and well-timed given the strong NZ Dollar. Increase weightings
to core Trans-Tasman stocks.
Performance since market peak in late May 2011
31-May 24-Aug Change Change v NZX50
NZX50 3,547 3,287 -7.3% Port of Tauranga $8.80 $9.36 6.4% 13.7% Sky TV $5.65 $5.70 0.9% 8.2% Auckland Airport $2.30 $2.28 -0.9% 6.5% TrustPower $7.40 $7.10 -4.1% 3.3% Mainfreight $10.03 $9.60 -4.3% 3.0% Ryman $2.71 $2.59 -4.4% 2.9% The Warehouse $3.66 $3.42 -6.6% 0.8% Fletcher Building $8.93 $7.85 -12.1% -4.8%
Source: Iress, Craigs Investment Partners
Key data - ranked by FY12 yield Gross YieldForecast PE
Company Code Price
Market Capitalistaion
(NZ$m) FY12 FY13 FY12 FY13
The Warehouse WHS $3.42 $1,058 10.1% 10.6% 12.9 12.2
TrustPower TPW $7.10 $2,239 7.6% 8.5% 18.8 17.3
Auckland International Airport AIA $2.28 $2,943 6.1% 6.7% 21.7 20.0
Fletcher Building FBU $7.85 $5,279 5.8% 6.8% 12.7 9.1
Port of Tauranga POT $9.36 $1,247 5.0% 5.5% 19.5 17.8
Sky TV SKT $5.70 $2,187 4.9% 5.6% 15.4 13.5
Mainfreight MFT $9.60 $969 3.8% 3.9% 14.1 13.1 Ryman Healthcare RYM $2.59 $1,275 3.0% 3.4% 12.0 10.6
BHP Billiton (BHP) – This commodity giant is now the 3rd
largest listed company in the world. Diversity and lowest cost producer are two key competitive advantages. Revenue is sourced 51% from ferrous (coal, iron ore), 28% from metals and 21% from energy (oil & gas). We believe it is the best placed of the miners to benefit from the expected future increase in demand for hard commodities.
Woolworths (WOW) – WOW has an excellent track record.
Providing above average earnings and dividend growth over the past 15 years, means it deserves its premium rating. It remains supermarket king and continues to drive internal growth. Its core business of food retailing (80% of earnings) is inherently defensive.
Coca Cola Amatil (CCL) – Difficult to match Coke’s brand
power. This brand underpins CCL’s market position and defensiveness of earnings. The trading environment is expected to improve over the year and we believe CCL can continue to deliver high single-digit profit and dividend growth. The company has a strong earnings and dividend growth track record. CCL is 32% owned by Coca Cola Inc (KO).
APA Group (APA) – APA holds an unrivalled position in gas
transmission with its 21,000 km of gas pipelines. It has been a strong performer for shareholders, delivering a high yield but also a rate of dividend growth that many stocks with far lower yields have been unable to match. Revenue is defensive but the company also offers growth potential as use of Australia’s abundant gas reserves rise from general use and also for power generation as Australia moves away from coal fired plants. Taxed under Fair Dividend Rate (FDR) regime.
MAp Group (MAP) - Now internally managed, and with
Sydney airport becoming the dominant asset, the company is an attractive infrastructure exposure offering an above-average dividend yield. The long-term operating outlook for MAP is strong with long run traffic growth of 4-5%. With it now internally managed and focussed on simplifying its capital structure and reducing debt, we see MAP as a good complement to holdings in Auckland International Airport. Same FDR tax status as APA.
AGL Energy (AGK) – AGK is a leading utility in Australia
with operations in retailing, distribution and generation. The company has assembled Australia’s largest privately owned portfolio of renewable assets. AGK is well placed to benefit from the government’s plan to add substantial renewable generation over the next decade. Wind farms will be a key component of this and AGK is an experienced wind farm operator. Such generation also needs retail off-take agreements and AGK has this base covered being Australia’s largest electricity retailer.
Australia
Fletcher Building (FBU) – There aren’t many major development
projects or infrastructure projects in New Zealand that FBU isn’t involved in. It has very strong market positions in construction and building supplies and will benefit from repairs to leaky homes, the Christchurch rebuild & government-funded increase in infrastructure spending in 2012. The Crane acquisition looks high quality and well-timed.
TrustPower (TPW) – This Tauranga-based generator and retailer of electricity has a defensive niche in its sector. It has a loyal customer base, strong renewables focus in its generation portfolio and overall has a low risk strategy which is leveraged to rising retail tariffs.
Sky TV (SKT) – The period of high growth is behind SKT, but it
has an unrivalled market and content (especially sport) position in New Zealand. The stock offers the potential for dividend growth and the MySKY HDi platform is generating uplift in revenue per customer as subscribers convert from the older platform.
The Warehouse (WHS) – A mature retailer with a strong market
share position. Offers leverage to any forthcoming recovery. The company’s distribution footprint would be difficult to replicate and corporate interest remains a future possibility. Its market share is defendable and it offers a sustainable yield. The company appears focussed on a strategy of re-invigorating the company’s offering.
New Zealand continued
Ramsay Healthcare (RHC) – RHC management has built a
very high quality private hospital business that has a strong position in Australia, along with attractive operations in France and other countries. The company’s defensive cash flows are supported by an ageing population and increased hospital occupancy. Management has a successful history of extracting synergies from acquisitions.
Newcrest Mining (NCM) – Gold (and copper) miner NCM
has six mines, five in Australia and one in Indonesia. It is Australia’s leading gold mining company and recently issued a strong result, including a special dividend. The company has a strong balance sheet along with an attractive development pipeline. We believe some gold exposure in a portfolio provides a degree of ‘safe haven’ appeal. NCM provides exposure to gold, as well as ownership of a significant operational company.
Commonwealth Bank of Australia – (CBA) – CBA has a
powerful retail and business banking franchise, a very strong deposit base and a high quality funds management business in Colonial First State. It is CBA’s leading retail position that stands it apart in the sector. Lower levels of credit growth will mean earnings growth for the banks will be more modest than in the past.
Westpac Bank (WBC) – With the acquisition of St George
Bank, WBC is now the largest bank in Australia with an estimated 26% of all bank branches throughout the country. WBC is a quality franchise, has a diversified funding base and is positioned with a conservative tilt, positioning it well in the current environment. Lower levels of credit growth will mean earnings growth for the banks will be more modest than in the past.
Cochlear (COH) – COH is a worldwide leader in the
manufacture and sale of hearing and cochlear implant systems used for the treatment of people with profound and severe hearing loss. Research & Development accounts for 10-15% of sales a year. This research expertise provides COH with its competitive advantage. We continue to believe COH is a high-quality franchise, and likely to sustain above average earnings growth over coming years. The high Australian Dollar is a headwind.
Australia continued
Key data - ranked by FY12 yield Gross YieldForecast PE
Company Code Price$A
Market Capitalistaion
(A$m) FY12 FY13 FY12 FY13
APA Group APA $4.00 $2,536 8.8% 9.0% 19.4 17.9 Westpac WBC $19.72 $59,755 8.0% 8.6% 8.9 8.2 Commonwealth Bank CBA $46.71 $72,806 7.5% 7.9% 10.0 9.6 Map Group MAP $3.17 $5,900 6.6% 6.9% 29.6 33.1 Woolworths WOW $27.27 $33,174 4.8% 5.2% 14.4 13.4 Coca Cola Amatil CCL $11.64 $8,826 4.8% 5.2% 14.9 13.9 AGL Energy AGK $14.15 $6,528 4.4% 4.6% 14.2 13.1 Ramsay Healthcare RHC $16.81 $3,397 3.4% 4.0% 14.7 12.7 Cochlear COH $74.61 $4,237 3.2% 3.5% 21.6 19.7 BHP Billiton BHP $38.21 $122,711 2.9% 2.9% 7.7 8.2 Newcrest Mining NCM $40.38 $30,891 1.2% 1.7% 16.9 13.0 Source: Craigs Investment Partners
Performance since market peak late May 2011
31-May 24-Aug Change Change v ASX200
ASX 200 4,708 4,167 -11.5%
MAp Group $3.09 $3.17 2.6% 9.9%
Newcrest $39.70 $40.38 1.7% 9.0%
Woolworths $27.41 $27.27 -0.5% 6.8%
Coca Cola Amatil $11.78 $11.64 -1.2% 6.1%
AGL Energy $14.37 $14.15 -1.5% 5.8% Cochlear $79.77 $74.61 -6.5% 0.9% APA Group $4.30 $4.00 -7.0% 0.4% Commonwealth Bank $50.62 $46.71 -7.7% -0.4% Ramsay $18.43 $16.81 -8.8% -1.5% Westpac $22.13 $19.72 -10.9% -3.6% BHP $44.36 $38.21 -13.9% -6.5%
Take a value approach when buying
Emerging Markets directly
Managers with a value orientation add a margin of safety to investing in
Emerging Markets
We believe share portfolios should include some direct exposure to Emerging Markets. However, we regard these markets as higher-risk than developed markets for a number of reasons including; lower standards of corporate governance, political risk and a heavy reliance on exporting to developed markets. In 1998, Emerging Markets fell sharply in the wake of the Asian financial crisis. Today, these economies have a much sounder footing with robust economies and high levels of foreign reserves. Nevertheless, we recommend clients look to access these markets through funds that have a ‘value’ approach in that the managers are very focussed on finding stocks that are cheap relative to fundamentals. Such a value approach reduces risk and provides a ‘margin of safety’ in our view because during the inevitable periods of market weakness, expensive growth stocks tend to decline the most dramatically while stocks that are reasonably priced are often more resilient.
Two such value funds that we recommend are Templeton Emerging Markets Fund (TEM), a core exposure to Emerging Markets around the world, and Scottish Oriental Smaller Companies Fund (SST), a niche holding providing exposure to small and midcap companies in Asia.
Templeton Emerging Markets Fund (TEM)
TEM is the leading Emerging Market listed investment trust with a market value of NZ$4bn. It is a core holding and has been a strong performer for many years. Over the past 20 years it has returned +13.8%pa versus a +8.7% return from the MSCI Emerging Markets Index. Its relative
defensiveness is illustrated by the fact that it has gained +2.5% over the past year when the Index returned -2.7%. Annual fees are fair for an Emerging Market fund at 1.3%pa.
Mark Mobius, who has managed
the fund since 1989, is a very dedicated value investor. Also, he only invests directly in countries where he is satisfied that sufficient custodial and other arrangements have been made to safeguard the company’s investments. In selecting stocks, he assesses a company’s share price in relation to its long-term earnings prospects, asset value and cash-flow potential. The company’s position within its sector, the economic framework and political environment are also considered. This defensive investment style has seen the fund outperform its benchmark and its peers over the long term, while minimising volatility.
In our view, TEM’s defensive style and long-term record of out-performance versus its peers makes it the best way of accessing the high growth, but high risk, markets in the developing world. While the dividend yield is low at 0.8%,
dividend growth has been strong at 10%pa since 1992. We view TEM as attractive buying at discounts of around 7% or greater.
Scottish Oriental Smaller Companies Fund (SST)
We recently hosted Susie Rippingall, the manager of SST on a conference call from Hong Kong. The investment objective of the Trust is to achieve long-term capital growth by investing mainly in smaller Asian quoted companies with market capitalisations under US$1bn at the time of investment. SST’s investment style is inherently conservative, focusing on capital preservation as well as capital growth. We like the fact that the fund manager pays particular attention to the potential downside as well as the upside when making any investment decision, which aids in reducing the risk to long-term returns. According to the fund manager, the companies SST invests in are typically simple businesses with strong balance sheets and robust cash flows. They also tend to provide a dividend stream and have more reliable earnings streams than their peers. This is evident in the fund’s performance history. SST has returned 15%pa for the past 10 years, versus a 6.1% return from the index.
The fund has 85 stocks and weightings are gradually increased as the manager becomes more comfortable with the stock and management. Of all the factors the manager considers, the quality of management rate as most important. The value benchmarks the manager typically uses are Price/Earnings and Price/Book ratios relative to their view of the growth outlook for each stock. The manager believes Asian markets warrant a defensive approach because it remains a region of above-average risk. We agree, and is why we believe value funds like SST and TEM are the most prudent way of accessing these markets.
Equities
Buy value-orientated funds Templeton Emerging Markets and Scottish Oriental Smaller Companies for a defensive-tilt to your Emerging Markets exposure.
Templeton Emg Mkts Geographical breakdown
Scottish Oriental Smaller Geographical breakdown China 14% Hong Kong 9% Taiwan 13% India 2% Indonesia 5% Malaysia 8% Philippines 4% Singapore 14% Sri Lanka 2% South Korea 13% Thailand 8% Vietnam 1% Cash 7% Hong Kong / China 26% Brazil 20% India 12% Thailand 11% Indonesia 9% Turkey 6% South Korea 6% Russia 5% South Africa 3%Mexico2%
Old-World defensiveness, New-World
growth
Get the best of all worlds by accessing Emerging Markets through
Global Leaders
The current financial crisis is centred on government finances. The corporate sector is well positioned with many companies having cash on hand and strong balance sheets. The vast scale and strong market positions of global leaders gives them an inherent degree of safety. Many also offer solid dividend yield, funded by low payout ratios, and have track records of rising dividends that go back decades in some cases.
These global leaders are also masters at allocating capital to areas where earnings growth can be sourced. It is therefore not surprising that many continue to build a growing exposure to Emerging Markets. We believe these world leading stocks offer: 1 Transparency that comes from US/European governance
standards;
2 Inflation protection from the pricing power that comes from having world leading brands and market positions;
3 Safety that comes from significant scale and financial strength;
4 Defensiveness because many operate in areas that are relatively resilient to the economic cycle, such as consumer staples, healthcare and financial services;
5 Growth from Emerging Markets operations – Emerging Markets has 80% of the world’s population, 50% of global growth and 33% of global GDP.
Competition is intense in these fast growing markets but the market still offers significant room to grow. Procter & Gamble (PG) now sources 35% of sales from Emerging Markets, and sales from this region are doubling every five years. PG estimates that Americans each spend $112 a year on its products while in China the figure is $3 and in India it is $1.
Equities
Global leaders exposure to Emerging Marekts - Ranked by sales from Emerging Markets
Stock Code % of sales from Emerging Markets Price Market Capitalistation (bn) FY12 Dividend
Yield Payout ratio Comment
HSBC HSBA 70% £5.12 £92.9 5.3% 37.7% Well placed, relatively conservative bank with obvious leverage to EM Unilever ULVR 52% £20.42 £36.2 4.0% 55.3% Best placed in EM of the consumer leaders. Brands include Dove,
Sunsik, Magnum
Nestle NESN 36% CHF49.44 CHF158.14 3.8% 68.7% A fierce competitor in EM with its food and wellness products Procter & Gamble PG 35% $63.02 $185.5 3.2% 48.4% Fast mover into EM with brands like Braun, Vicks, Max Factor 3M MMM 34% $79.67 $56.7 2.9% 32.7% Easier to list what it doesn't make. Famous for its consumer products
Coca Cola KO 34% $67.97 $160.0 3.0% 48.0% 51% share of soft drink market worldwide. Unrivalled global brand power
Diageo DGE 30% £11.22 £17.0 3.9% 50.4% Sales of its premium drinks (Smirnoff, JohnnieWalker) growing strongly in EM
Johnson & Johnson JNJ 27% $64.97 $180.3 3.7% 45.5% Diverse range of consumer and healthcare products Reckitt Benckiser RB/ 25% £32.86 £14.7 3.8% 50.0% Household and personal care leader. Harpic, Mortein, Nurofen Apple AAPL 22% $374.00 $349.9 0.0% 0.0% Apple products hugely popular right across the world GlaxoSmithKline GSK 15% £12.98 £39.9 5.6% 62.1% Definitive decision to move focus away from Developed to EM Tesco TSCO 15% £3.77 £18.7 4.1% 44.5% UK's largest retailer has ambitious offshore growth plans
Average 3.6% 45.3%
Buy Global Leaders with growing Emerging Markets sales for defensiveness and growth.
Unilever (ULVR) – Provides the highest level of exposure to
Emerging Markets of the global leading consumer staple stocks with 52% of revenue sourced from here. Key brands include Dove, Sunsilk, Rexona, Lynx, Surf, Lipton and Magnum. Like the other consumer staples, Unilever has outperformed in a falling market. This defensiveness in tough times is a key attraction of the sector in our view.
Nestle (NESN) - The world’s #1 food company in terms of sales.
Products include instant coffee, baby formula, bottled water, beverages, milk products, culinary products, frozen food, ready-to-eat dishes, refrigerated products, food service products, pet food, pharmaceuticals, cosmetics, and of course, chocolate. Nestle also owns Jenny Craig and 26% of L’Oréal. The company has grown its dividend by 14%pa since 1996 and still trades on a relatively high yield of 3.8%. It has also displayed strong defensive attributes, providing a return of +7.9%pa over the past 3 years when the market returned - 4.6%pa.
Coca Cola (KO) – Buffett’s favourite stock for good reason. KO
has an unrivalled brand, high return on capital and plenty of growth potential in Emerging Markets (34% of sales come from Emerging Markets). The fact that it has grown its annual dividend every year for the past 49 years is also reasonably compelling. It has beaten a weak market by 9.9% a year over the past three years and provides a 3.0% dividend yield.
Reckitt Benckiser (RB/) – One of Europe’s strongest consumer
franchises. RB has a strong balance sheet, strong cash flows and a reliable and increasing dividend. Brands include Finish, Strepsils, Harpic and Dettol, to name a few. Offers a yield of 3.8% and above-average growth potential.
3M (MMM) – The company has a long list of brands like Scotch
Tape, Nexcare, Post-it and applies significant research spend on searching for the next ‘home run’ product. A best in class Emerging Markets exposure, attractive operating margins (c25%), a strong pipeline of new products and an enviable balance sheet (cash of US$5bn) to support further growth.
Diageo (DGE) – Has a 28% global share of the premium drinks
market. Brands include Smirnoff, Baileys, Guinness and Johnnie Walker. A direct beneficiary of rising incomes in Emerging Markets. The company also has a strong dividend focus, it trades on a yield of 3.9% on a 50% payout ratio and the company has delivered dividend growth of 7.7%pa over the past 19 years.
Six Staple Stocks - for Defensiveness, Yield
and Emerging Markets exposure
Being defensive - Consumer Staples have beaten a weak market
Stock 3yr return (NZD)
%pa vs MSCI %pa MSCI -4.6% Nestle 7.9% 12.5% Coca Cola 5.3% 9.9% 3M 3.0% 7.6% Diageo 1.6% 6.2% Unilever 1.4% 6.0% Reckitt Benckiser -2.7% 1.9%
Equities
Consider Contrarian Investments
Non-conventional stocks can provide some ballast during market falls
This article follows on from a note we wrote on 17 May 2011 entitled ‘In future share portfolios may look more like hedge funds’. In it we suggested that our portfolios might, in future, combine our conventional holdings in cash, bonds and quality equities with a small 5% to 10% allocation to some ‘contrarian’ investments that have the potential to provide some protection against losses when markets fall.
The recent sharp decline in markets provides us with a live test case that we can use to revisit these funds to see how they performed, and ascertain whether they lived up to their potential to provide some ballast against falling markets. Generally, they performed as they should have, either rising in value or at least falling by much less than the market. See table below.
Performance of Alternative funds during the market fall: 22 July 2011 - 10 August 2011 Holding Return (Local) Description
S&P 500 Index -16.7% US market index , top 500 companies. Pied piper for world markets
NZX50 Index -10.2% NZ market
Bluecrest AllBlue (BABS.L) -6.1% Hedge fund of funds (internal funds) listed in the UK
Ruffer Inv Trust (RICA.L) -4.6% Niche, absolute return fund with a concentrated portfolio
RIT Capital (RCP.L) -4.0% Core holding. Absolute return fund. Widely diversified.
Newcrest (NCM.A) -1.9% Australia's leading gold miner
US Treasuries ETF (BIL.US) 0.0% US Cash ETF investing in short term US Treasuries
Gold ETF (GLD.US) 11.8% World's 6th largest owner of gold. Index fund on gold bullion
S&P 500 Inverse ETF (SH.US) 18.5% Inverse ETF on the S&P 500. Seeks to track only daily changes
MSCI EAFE Inverse ETF (EUM.US) 19.4% Inverse ETF on the major markets ex-US. Seeks to track only daily changes
VIX Index ETF (VIXY.US) 69.1% An ETF that seeks to track the VIX Index (an index of option pricing/risk)
Average return of contrarians 11.4%
RIT Capital (RCP.L) – This well-regarded and well–performed fund is a core holding anyway. Mitigating downside risk is a key objective of the management team, which it achieves through market timing and more importantly by holding gold, land and other assets that have a lower correlation with equity markets within the portfolio.
Ruffer Investment Trust (RICA.L) – An interesting niche holding
that can sit alongside RIT Capital. The manager’s approach is concentrated in significant but, in the manager’s view, offsetting positions. The portfolio is currently made up of US/European equities 33%, inflation bonds 29%, Japanese equities 25%, gold 6%, cash 4% and options 3%. The management fee is a flat 1% with no performance fees, which is good to see.
Gold– A portfolio should have some gold exposure as it tends to perform well during periods of heightened risk, as we have seen recently. See our article on page 18 for more discussion. Access can be obtained either via gold miners like Newcrest, the gold miners index fund (GDX.US) or bullion can be purchased directly via a gold ETF like GLD.US.
US Dollars – The US Treasuries ETF (BIL.US) is returning zero
in US Dollar terms, which isn’t surprising given US short term interest rates are virtually zero. However, the kicker for New Zealand investors is that when risk escalates, the US Dollar usually appreciates relative to the NZ Dollar, even, as we have seen over recent weeks, if a good deal of the risk originates
from the US itself. We have serious concerns over the long-term outlook for the US Dollar, but as a hedge to risk, it can play an important role in a portfolio.
Bluecrest AllBlue Hedge Fund (BABS.L) – Like most hedge funds, BABS is a black box and the strategies of the various funds within it are highly complex and lack transparency. Fees are also high with the usual 2% annual fee plus 20% performance fee applying – although the underlying funds incur no fees which avoids a double layer of costs. At least its listed, which means pricing is transparent and we can expect a certain degree of reporting. And, the manager has a good track record, and the strategies they employ have the potential to outperform in difficult markets. Should be a modest holding.
VIX and Inverse ETFs (SH, VIXY, EUM)– These funds performed well during this most recent bout of market weakness. However, we maintain a cautious view on the Inverse funds as they are structured to track the inverse return of the underlying index for only one day. This can lead to large tracking errors and at times these funds fail to deliver the downside protection that investors expect. We also have concerns about the VIX Index Fund as this attempts to track the underlying index using futures, which again can lead to periods of significant tracking error. Despite these drawbacks, they can be interesting niche holdings that have the potential to provide some downside protection to a portfolio during periods of market weakness.
Contrarian funds to Buy as a
hedge to market falls
Given these funds can have the potential to provide some downside protection during falling markets, we believe portfolios could accommodate a modest (5% to 10%) allocation to these ‘contrarian’ holdings. However, there is no free lunch. Most offer no income, and hence the cost of owning them is the lost income you would have earned if this capital was invested in fixed income or equities. As detailed below, none are perfect hedges in the way that a direct short position or futures position would be, but we believe they can still add value to a portfolio.
Source: Bloomberg, Craigs Investment Partners
Low interest rates may attract buyers
to high income stocks
Add some high yield stocks to boost income. These stocks could also see
increased buying pressure from investors seeking to replace interest income
It is reasonably clear that; 1) Interest rates are going to stay low for an extended period, and 2) Credit growth will be flat as households deleverage. Both factors point to a period of low deposit rates for fixed income investors. This could continue to lead to a ‘search for income’, which could underpin the share prices of companies that are providing high dividend yields.
However, when looking at higher yield stocks we need to be conscious that they are trading on high yields for a reason – the market believes the company has low growth prospects, or worse, the
market believes the dividend may fall in future. At times, stocks trade on high yields simply because the dividend is uncertain. The outlook for the stock’s sales and profits are difficult to forecast and therefore the market attaches a discount to the dividend to account for this risk.
For this reason, we recommend portfolios that include higher yield stocks also include lower yield/higher quality stocks. The 18 stocks below offer high yields and have a range of risk profiles;
The most defensive of these high yield stocks that, in
our view, have the most ‘reliable’ dividends: APA Group, Westpac, Scottish & Southern, City of
London, Henderson Far East Income, HICL Infrastructure, Property for Industry, Vector, Vital Healthcare
Higher risk contrarian stocks that are offering high
yields because they face a degree of uncertainty and have been marked down by the market:
Telecom, Telstra, Vodafone, GlaxoSmithKline, QBE
Cyclical stocks that financial performance to varying
degrees depends on the performance of the economy and/or markets:
The Warehouse, IOOF, Amcor, Cavalier, Statoil
Higher Yielding Stocks
Stock Code FY12 FY13 Payout ratio Comment on yield
Telecom TEL 10.3% 11.3% 88% High yield reflects uncertain outlook
The Warehouse WHS 10.1% 10.6% 94% Limited growth
Vital Healthcare VHP 9.7% 10.1% 100% Focus on development means slightly higher risk profile
Property for Industry PFI 8.6% 9.0% 100% Should be sustainable
Cavalier CAV 8.3% 10.6% 73% Cyclical
Vector VCT 8.3% 8.3% 79% Defensive cashflows
Average 9.2% 10.0% 89%
Telstra TLS 9.2% 9.2% 104% High yield reflects uncertain outlook
QBE QBE 9.1% 9.1% 78% Low US interest rates mean flat (at best) dividend
APA Group APA 8.8% 9.0% n/m Good level of dependability
Westpac WBC 8.0% 8.6% 71% Growth will be lower than in the past
IOOF IFL 8.0% 8.4% 104% Above average level of defensiveness
Amcor AMC 6.6% 7.6% 77% Cyclical but operationally robust
Average 8.3% 8.7% 87%
HICL Infrastructure HICL 5.8% 5.8% 95% Quality assets but growth will be modest
GlaxoSmithKline GSK 5.4% 5.7% 62% Faces increased competition
Statoil STL 5.2% 5.2% 32% Results depend on oil price movement
Henderson Far East Income HFEL 5.1% 5.1% 85% Defensive yield from diverse portfolio
Scottish & Southern SSE 4.9% 5.2% 71% Reasonably defensive cashflows
City of London CTY 4.8% 4.8% 85% UK blue chip portfolio underpins yield
Vodafone VOD 4.2% 4.5% 59% Fast moving, and risky, sector
Average 5.1% 5.2% 70%
Source: Bloomberg, Craigs Investment Partners
Equities
Buy a selection of quality higher yielding stocks.
Give your portfolio a Spring Clean
Review underperforming or high risk stocks, some better options may be available
We recommend portfolios be regularly reviewed. This review process is especially important during difficult markets as we have now. If the economic outlook worsens and financial conditions tighten (investors become more defensive, liquidity dries up and spending reduces) stocks that have weaker business models and high levels of debt can get marked down, and any recovery can take a long time. Every client’s portfolio (and risk profile) is different, but we generally recommend that in tough markets, higher risk
holdings be replaced by more defensive companies that provide access to the same theme or sector, but with less risk. Or, to move to stocks that have more potential for upside than the existing holding. Having said that, some stocks may not deserve the de-rating the market has placed on them and should therefore be held on to, in our view. While it is impossible to cover all stocks held by clients, below we have reviewed a selection of stocks that have underperformed, or for some other reason warrant attention.
Stock Recommendation Reasoning
Fisher & Paykel
Healthcare (FPH) Hold. Underlying business remains sound. With 98% of sales outside NZ, we need to regard it as a US stock. Has performed badly compared to NZ stocks, but in line with US stocks.
FPH has been the most disappointing of our key core holdings over recent years. Over 2yrs it has returned -8.5%pa versus a 6.1%pa rise in the NZX50 and 11.4%pa gain in our Core NZ Portfolio. The strong NZD is the prime culprit, although some aspects of the hedging management and marketing of new products, appear to have contributed in some way as well. Nevertheless, it is one of NZ's highest quality companies and difficult to replicate. The yield is attractive and we recommend holding on.
Contact Energy
(CEN) Hold. Price now reflects mixed operational performance. CEN's assets are very high quality but operationally, this company has been disappointing over recent years. TrustPower and AGL Energy offer lower risk alternatives, but retain a core weight to CEN as a turnaround will come eventually, and Origin corporate angle still a possibility at some point.
Rakon (RAK) Sell. For midcap exposure we prefer Hellaby (HBY) , Seek (SEK), Opus (OIC). For technology we prefer Apple (AAPL).
Good sales volumes are not translating into earnings. Pricing power is low and we believe the risk/return trade off does not warrant maintaining an exposure to RAK.
Guinness Peat
Group (GPG) Sell into strength and shift to stocks offering better yields and potential for income growth.
GPG is now in a phase of asset realisation. There are some risks around this process in terms of value and tax however, the current price appears to fairly price these risks and the potential upside that will come from asset selldowns. However, we recommend clients focus on better quality stocks offering more growth and that provide dividend income.
Goodman
Fielder (GFF) Sell and move funds to more defensive names, Woolworths (WOW) and Coca Cola Amatil (CCL).
The difference in performance between GFF and WOW/CCL is a clear illustration of the relative safety of a price taker like GFF and a price maker like WOW and CCL. We believe WOW and CCL are more defensive ways to access the food sector.
Origin Energy
(ORG) Reduce exposure (by circa 50%) and add AGL Energy (AGK) which offers a lower risk mix of assets and higher yield.
This switch is not without risk in that you give up the potential upside from ORG's LNG developments. However, on balance, we believe the delays with the LNG project, along with the fact that it appears to us ORG overpaid for NSW retail assets mean it is prudent to switch to the more defensive AGL Energy with its unrivalled mix of retail, distribution and generation assets, higher yield and exposure to renewables. Westfield (WDC) Reduce (by c.50%) in light of a softer
outlook for retail and move to LPTs in other sectors, such as Vital Healthcare Prop (VHP), Property for Industry (PFI) and Goodman Property (GMT).
The recovery in consumer spending in WDC’s northern hemisphere markets looks likely to take longer than anticipated. Australian households are also being squeezed by higher interest rates and inflation on food and fuel. The soft housing market in both Australia and the US are not conducive to a return to consumer confidence.
QBE Insurance
(QBE) Hold. Low US cash rates dragging down earnings. QBE's share price has fallen heavily on the news that US cash rates will be staying low until 2013. Given it conservatively invests a good proportion of its balance sheet in cash, the fact that these investments are generating very low income is having a direct impact on earnings. Therefore the dividend is going to be flat, at best, over the next 24 months. However, it remains our preferred insurance sector expsosure and we recommend maintaining holdings.
JP Morgan
Overseas (JMO) Sell and move funds to value/absolute return/income funds that are more defensive in a volatile market, such as Bankers (BNKR), British Empire & Securities (BTEM) or RIT Capital (RCP).
This is no time for high beta growth orientated funds. JMO roared in the 3 years up to 2007 then significantly underperformed a falling market in 2008. It then outperformed again in 2009 as markets recovered. However, it has struggled recently as markets have been more difficult. We prefer lower beta (less volatile) funds with a value/absolute return/income orientation such as BNKR, BTEM and RCP as we believe they will better handle what could be a difficult market over coming years. Recent performance is a clear illustration of this point; from July 22 to August 16 when markets fell sharply, JMO fell 14% while BNKR and BTEM fell a more modest 8%. AMP WiNZ
Index Fund (WIN)
Exit and replace with global investment trusts like Bankers (BNKR), Monks (MNKS) or Murray International (MYI) or a low-cost ETF such as Vanguard World (VT).
WIN is over-exposed to the US market and is higher cost than other passive funds. Investment Trusts provide a managed exposure for approximately the same cost or the Vanguard ETF provides a more diverse and lower cost exposure for clients wanting a passive exposure.
Stocks under review
Equities
US Midcaps have trounced US Large Caps since 1995
Source: Bloomberg, Craigs Investment Partners 0 100 200 300 400 500 600
May-95 May-97 May-99 May-01 May-03 May-05 May-07 May-09 May-11 MDY has delivered a total return of 300%, or 9%pa...
...while SPY has produced a total return of 120%, or 5%pa SPY
MDY
Source: Bloomberg, Craigs Investment Partners
The Magic of Mid-Caps
We believe Mid-Caps have a ‘sweet-spot’ that produces higher returns – they
are big enough to survive, yet small enough to grow
We have always held a soft spot for Mid-Cap stocks. A look at how much they have outperformed in the US would suggest we should ensure portfolios include an allocation to these stocks. We use the term capitalisation to describe the total value of a company’s shares. For instance, Fletcher Building is New Zealand largest listed company because its 678 million shares on issue multiplied by its latest share price of $7.91 (as I write this) equates to $5.4 billion. To save ink, we shorten the word Capitalisation to ‘Cap’. Fletcher Building is a Large-Cap company. Companies that are big enough to graduate from being called ‘Small-Cap’ companies, yet aren’t big enough to enter the ranks of the large companies are termed ‘Mid-Caps’. There is no fixed level at which a stock graduates from being Small, Mid or Large Cap, and it varies across markets. What we deem to be large in New Zealand is likely to be seriously mid-sized in a large market like the US.
MDY versus SPY
To compare the performance of Mid-Caps to Large-Caps we have used US data because it has the scale to overcome the stock specific biases we see in our local data. Our task is made much easier
by the fact that in the US there are two Exchange Traded Funds, one covering Large-Caps, the SPDR S&P 500 ETF (SPY) and another covering Mid-Caps, the SPDR S&P 400 ETF (MDY). SPY holds a portfolio of the largest 500 listed companies in America, the MDY fund holds a portfolio of the 400 companies immediately below the top 500. This leaves the other 2000 or so companies on the US stock market, which are herewith deemed to be Small-Caps.
Over the 16 years since 1995, MDY has trounced SPY, having provided a total return of 300% versus SPY’s 120% total return. And this return has been achieved with only modest extra risk with MDY’s monthly returns being just 11% more volatile than SPY’s.
Mid-Cap Sweet Spot
When considering why Mid-Caps have tended to do better than their Large-Cap cousins over the past 16 years, it seems feasible to us that there is something of a ‘sweet spot’ for
Mid-Caps. Factors in their favour we believe are:
They are bigger than Small-Caps and hence have an inherently higher degree of defensiveness;
They have built and proven their business model and carved out a market position;
They also typically have a stronger financial footing than smaller companies; but also
Unlike many Large-Cap stocks that have mature businesses with little prospect for further growth, Mid-caps tend to still be in the growth phase of their life cycle and consequently can achieve above-average rates of earnings growth.
Recommendations
Include MDY in global portfolios. Closer to home, look to include a selection of Mid-Cap stocks that have the characteristics that appear to help the US Mid-Caps outperform, namely enough scale to be able to handle tough economic conditions and rising competition, but also plenty of growth potential. Some potential candidates include Ebos (EBO), Opus Consulting (OIC), Hellaby Holdings (HBY) and Seek (SEK).
Equities
Include the US Mid-Cap Index Fund (MDY) in portfolios along with a selection of New Zealand and Australian Mid-Caps.
Name Code Price F/c Yield Comment
SPDR S&P 400 MidCap ETF MDY.US $151 1.1% Low cost exposure to the 400 US companies immediately below the top 500
Ebos EBO.NZ $6.65 6.50% Distributes healthcare products. Ageing population supportive to demand
Opus Intl Consulting OIC.NZ $1.90 7.30% Quality engineering firm which should benefit from construction pick-up
Hellaby Holdings HBY.NZ $2.60 5.40% Restructured businesses poised to deliver earnings growth over time
