Rudi's View | Sep 12 2019
Dear time-poor reader: The All-Weather Portfolio is generating more income while better protected against share market shenanigans. Here's how we did it.
In this week's Weekly Insights:
-A Joke For The Times
-The Right Lessons To Learn
-Yield At Uncorrelated Protection
-Rudi On Tour
Special note: there will be a Part Two comprising of broker Conviction Calls and remaining insights from the August reporting season, which will be published on Friday on the website.
A Joke For The Times
It is the year 2525, and man is still alive, but he's had to battle raging bush fires and rising sea water levels among many other impacts from climate change.
The world is now divided over three competing populist dictatorships that battle each other for what is left in fresh water and other crucial resources.
And the UK is considering organising its next referendum to decide whether it wants to leave the EU, or not.
(I recently told this joke while co-MC-ing the Conference Dinner with Julia Lee at the AIA National Investment Conference on the Gold Coast).
The Right Lessons To Learn
By Rudi Filapek-Vandyck, Editor FNArena
Probably the best way to describe the performance of the FNArena/Vested Equities All-Weather Model Portfolio into the new financial year is by making the following observation: the All-Weather Portfolio has rallied to a fresh all-time record high, while key local share market indices might need half a week of unrestrained upside to get there.
The difference in performance has been achieved on the back of yet another heavily polarised August reporting season in which yet again sharp differences were laid bare in operational performances between companies often operating inside the same sector.
This has now happened so often in recent years, investors should probably start asking the question as to whether we are experiencing a "new normal" for corporate Australia, and for investors trying to balance risks and potential rewards.
Quality, The New Diversifier
Citi analysts, in a post-August sector update on REITs in Australia, formulated it succinctly when they observed: "Earnings growth and upside surprise [are] becoming more concentrated".
This is not just something that characterises listed property stocks in Australia today. This observation equally applies to other sectors, like retail and miners. A clear case can be made that the Australian share market in its entirety is now sharply divided between Haves and Have Nots, with significant consequences for anyone looking to invest long term.
The most significant observation, on my assessment, is that a relatively low valuation increasingly corresponds with higher operational risks. Certainly, this has probably always been the case, but in the past your typical bottom dwellers and value investors seemed to get away with "buying cheaply" more often than not, as the share market always shoots first and share prices tend to overshoot to the downside.
Not anymore. The August reporting season had barely finished or share prices for Incitec Pivot ((IPL)) and CYBG ((CYB)) had yet to endure another profit warning from company management. The first one was pretty much anticipated as fertiliser prices remain lower-for-longer, but it still surprised to the downside. The latter warning came completely out-of-the-blue.
Which is why CYBG's share price shellacking was so much worse than how the market responded to Incitec Pivot's disappointment. Equally important: since Incitec Pivot is a highly cyclical business, contrarian investors have already started speculating whether this latest disappointment marks the bottom for this cycle?
To be fair, August included some spectacular sell-offs for High Performance Achievers including a2 Milk ((A2M)), IDP Education ((IEL)) and Nearmap ((NEA)), but in most cases this happened on the back of a mere "technicality" such as management deciding to invest more to secure more growth further out, or the initial underperformance of a recent acquisition. It would be an incredibly brave call to now conclude these companies have turned ex-growth.
Fast growers can end up in dire straits, there's no denying the obvious, and August showed that once companies get mired into serious struggles it's best to adopt a cautious and conservative approach. See Blackmores ((BKL)) and Bellamy's ((BAL)), for instance, but also 3P Learning ((3PL)), Ardent Leisure ((ALG)), Arq Group ((ARQ)), The Citadel Group ((CGL)), Bega Cheese ((BGA)) and a whole battery of other examples.
The underlying observation remains intact though: most profit warnings and serious disappointments stem from challenged companies and from business models under pressure. Most often these are the share prices that lag the upward momentum that has allowed the Australian share market to rise more than 20% year-to-date.
High Quality Continues To Prove Its Value
For years now I have been advocating investors should distinguish "High Quality" from the rest in the Australian share market. Those who have been following my market observations and analyses would have noticed there were no profit warnings from High Quality structural growth companies such as CSL ((CSL)), REA Group ((REA)) or ResMed ((RMD)); an observation that extends beyond the recent August reporting season.
In addition, I also believe investment strategies are best served by distinguishing the emerging disruptors from the increasingly disrupted. A substantial part of the polarisation in equities that started taking shape around 2014 can be explained by looking at the investment landscape from such perspective.
Here I believe the August reporting season has provided investors with an important piece of insight: many of the companies that fall either under the umbrella of "High Quality" or of "emerging structural growth" on the back of technological disruption are able to continue to grow their sales and profits, even during times of global deceleration, macro uncertainty and widespread corporate duress.
This is why I disagree with those strategists who believe the better valued segments of the share market -High Quality & Growth- shall turn into major victims when the proverbial hits the fan.
The August reporting season has once again provided plenty of evidence risk is most prevalent among the lowly valued peers that are struggling most and most likely to issue a profit warning when the squeeze is on. Looking into the past and assuming investors will automatically seek safety among lowly valued, but more vulnerable businesses, seems way too simplistic to me.
Having said this, investors still need to take into account that were panic to hit financial markets again, smaller cap stocks will still take a bigger hit than large cap stocks simply because of the flow of money.
And stocks that are perceived to be trading at an elevated premium might be hardest hit initially. During the Big Sell-Off in late 2018, there were times when virtually nothing offered genuine safety other than cash and gold, and indeed, government bonds (but not necessarily corporate credit).
That too should be a valuable lesson learned.
Yield At Uncorrelated Protection
Probably one of the most surprising observations is that, on a net basis, money continues to flow out of US equities with much of it finding a new home in government bonds – at historical low rates.
US market strategists at Citi recently observed the broad S&P500 index in the US has risen beyond 60% (total return) over the past five years, yet US-oriented equity mutual fonds and ETFs have seen cumulative net outflows over that same period of -$300bn.
In similar fashion, most of the market updates and strategy reports I read over the past two months or so are mentioning elevated risk and why investors should build a buffer in cash, just in case. Most fund managers I read have been increasing cash in portfolios. Yet equities, both locally and overseas, always seem to find a way to resume the uptrend.
It seems counter-intuitive or is this why they call it the most hated bull market in history? Certainly, a simple "it's the weight of money" won't do as a satisfying explanation.
No time to be complacent
Share markets can still grind or rally higher, there is no doubt about that, and I see such forecasts on a daily basis, but I also agree with the majority voice this is not a time to be overly complacent about the risks that potentially lay ahead.
Early 2016 and late 2018 might be distant memories now, but they did happen, and there is absolutely no guarantee something similar cannot happen again (despite the fact the Fed is no longer tightening, which is a major difference).
We have as yet seen no reason to move significant volume out of equities and into bonds, gold and cash. So to prepare the All-Weather Model Portfolio for (potentially) a tougher environment ahead, I decided to look for non-share market correlated ways to protect against capital erosion while also lifting the overall income profile for the Portfolio as a whole.
All of a sudden, I found myself in exact the same position as many retirees who only recently decided to put more cash to work, only to find themselves caught in between a rock and a hard place; fearing a major correction in equities might do a lot of damage to their capital base, but at the same time, they need extra income.
The problem with seeking yield in today's share market is that most quality income providers are well-priced, while those still offering a reasonable yield in most cases come with higher risk operationally, which is why their share prices have lagged. Investors pay attention because this is how ALL financial markets work, including bonds and corporate credit. Higher yield/income means by definition higher risk.
Not making things any easier is the impartial observation that most financial assets have had a great run over recent years, and real value without excessive risk might well have become the Unicorn of our time. Certainly, there are scenarios at hand whereby all major assets -government bonds, corporate credit, equities and property values- can end up losing one's capital, all at the same time.
Is it still possible to find true diversification in one's portfolio while adding capital protection and extra income?
Searching For Yield, While Not Ignoring Risk
I think the answer is still positive. The FNArena/Vested Equities All-Weather Model Portfolio has re-allocated most of its cash into income generating assets that, on my assessment, should not follow the share market downwards in case of major risk-off volatility, while also generating an attractive, steady income. These are listed assets.
Firstly, so we are all on the same song sheet, the All-Weather Portfolio had kept a relatively large allocation in cash throughout the final months of 2018 and the first half year of 2019. We had moved some cash back into the market, but rather selectively. Most of that cash has contributed positively to the (out)performance into the new financial year.
Apart from carrying 18%-19% in cash, which we park inside a cash ETF, we also owned two investments, including a corporate bond expiring in less than 18 months, which we no longer wanted to own. All in all, we decided we have around 20% that can be re-allocated with the double aim of generating extra-income while also buffering the Portfolio for when times get hairy in the share market. We are still running circa 5% in cash, while receiving additional income from paid out dividends.
After conducting my research, which included rejecting a large number of options that failed to meet the criteria, sometimes by simply looking up the price chart for the past years (we explicitly don't want share market synchronicity), we decided upon the following re-allocations:
-Gryphon Capital Income Trust (GCI)
-MCP Master Income Trust (MXT)
-Perpetual Credit Income Trust (PCI)
These four additional investments now account for circa 19% of the Portfolio. Add the cash and about one quarter of the Portfolio is currently not invested in the share market and, on my assessment, equally non-correlated with any share market turmoil.
Gold, of course, doesn't generate any cash income, but it functions as a contra insurance policy when all other financial assets threaten to go to hell in a basket. The three new income generating assets have lifted the average forward looking yield profile of the All-Weather Portfolio to above 3%, plus franking.
Mind you, at 3% yield/income this Portfolio now has become an ideal vehicle for retirees looking for an alternative avenue other than simply buying Australian banks, Telstra and a handful of other yield stocks in the share market. I intend to write a more detailed assessment of this statement at a later stage.
Note that if we are to encounter another repeat of late 2018 or early 2016, nothing is stopping us from shifting more funds out of equities and into cash, if that is our choice.
To all investors looking for that specific yield/income alternative: do your own research. All our choices are publicly listed vehicles. There are copious volumes available in info, data and research.
Yield Is Never Risk-Free
Many investors are by now owning yield instruments varying from single company credit to bond ETFs and numerous alternatives in between, or they are now considering owning them. A few points of risk assessment you should consider:
-Corporate bonds are not without risk, especially not during times of economic stress. See also Pioneer Credit ((PNC)) listed on the ASX, or CF Asia Pacific Group (CFAP), not listed on the ASX but its debt might turn out worthless.
-A corporate bond with expiry date within the next two years or so will ignore the trends in cash rates and government bonds and trend towards nominal value. Payout on the date of expiration is 100% of the bond value.
However, given the global trend in recent years, this bond is likely to trade at a higher price, say 108 instead of 100. This means you are giving up more than the bond is yielding in capital erosion from here onwards. Something you should be aware of.
-Bond ETFs are useful, but they don't protect against capital losses in the same fashion as an individual bond with set expiration date does. If the trend in global yield reverses, or in case global government bonds experience a serious correction, your standard bond ETF will reset in line with lower bond prices, and you might not be able to make up for the commensurate loss in capital.
Also note: even though the Portfolio has never been fully invested, in the share market or elsewhere, this has not stopped the All-Weather Portfolio from outperforming the ASX200 Accumulation Index most of the times during its 4.5 years of existence.
Below is a repeat from last week's performance update:
All-Weather Portfolio Performance
The FNArena/Vested Equities All-Weather Model Portfolio significantly outperformed the broader share market in August with several portfolio constituents posting sizable rallies upon releasing financial results. Only a small number genuinely disappointed.
Whereas the ASX200 Accumulation Index dived deep in the red, and recovered somewhat during the final days of the month, to post a -2.36% loss following a positive performance of 2.94% in July, the All-Weather Portfolio posted gains of 2.95% in July and 0.47% in August.
The combined performance for the All-Weather Portfolio over the first two months of the new financial year is thus 3.43% compared with 0.52% for the ASX200 Accumulation Index.
Audio interview from last week
Rudi On Tour In 2019
-AIA and ASA, Perth, WA, October 1
-ASA Hunter Region, near Newcastle, May 25
(This story was written on Monday, 9th September 2019. It was published on the Tuesday in the form of an email to paying subscribers, and again on Thursday as a story on the website. Part Two this week will be written on 11 & 12 September and published on Friday).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: email@example.com or via the direct messaging system on the website).
BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS
Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:
– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.
Subscriptions cost $440 (incl GST) for twelve months or $245 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): https://www.fnarena.com/index2.cfm?type=dsp_signup
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)