Rudi's View | Nov 08 2019
Dear time-poor investor: what is the best way to invest in equities for regular income?
In this week's Weekly Insights (this is Part Two):
-Market Rotation? It's Complicated
-Focus On Quality Yield
-Fortescue Is No Mystery
–Tickets to Conference on Agricultural and Veterinary Biotechnology
-Rudi On Tour
[The non-highlighted items appeared on Thursday in Part One]
Focus On Quality Yield
By Rudi Filapek-Vandyck, Editor FNArena
It is the subject most share market experts and commentators rather not talk about: buying cheaply priced stocks works best when interest rates are higher, economic growth and cycles are relatively robust and there is no mass-disruption from eroding barriers of entry and technological innovations.
The current environment is different. Interest rates are exceptionally low, and likely to move lower still. Economic growth the world around post-GFC has never been quite the same, and the overall pace remains low by historical standards. And change caused by innovations: where exactly do I start?
The direct result is that corporate throwbacks, missteps and failures are not necessarily temporary in nature, as was mostly the case pre-2012. At the very least, the past number of years have taught investors cheaply priced companies might find it hard to sustainably improve their operations and thus catch up with the prolonged bull market in equities.
It is but one reason as to why 80-92% (small caps – large caps) of actively managed funds in Australia, according to a recent sector update by Morgan Stanley, are unable to keep pace with their benchmark, let alone decisively beat it.
Plenty of examples to choose from. In the healthcare sector, far and away the best performing in Australia, plenty of fund flows preferred Healius ((HLS)) these past years, instead of the much more "expensive" looking Cochlear ((COH)), ResMed ((RMD)) or CSL ((CSL)). Yet it's the "cheaper" one out of these four that has, on balance, hardly performed on a five year horizon.
Amongst REITs, equally one of the better performing segments on the ASX, the likes of Goodman Group ((GMG)) have at times become the focus of short-positioning, but the share price consistently moved upwards, at least until the mini-correction in August this year.
Once upon a time, Goodman Group shares were highly sought after by income hungry retirees, but these days the shares only offer circa 2% forward looking. That can serve as an indication of how "expensive" those shares have become.
There is no doubt in my mind income seeking investors have instead been preferencing REITs such as Vicinity Centres ((VCX)), which still offers circa 6% yield. On the flip side, Vicinity shares have eroded some -23% since their peak in mid-2016 and have largely trended sideways throughout 2019 when most market indices added near 20%.
Amidst an ongoing tough outlook for industrials in Australia, investors might take heed from the observation the increasing number of profit warnings and negative market updates are accompanied by a reduction in the dividend for shareholders. Already I have seen predictions of a lower payout by Vicinity Centres in 2020, and, post this week's profit warning, Medibank Private's ((MPL)) FY20 dividend might be at risk too.
Probably the most striking examples have come from the banking sector, in particular in Australia prominently represented in investment portfolios. If it isn't because of the dividend appeal, it's otherwise because the sector remains by far the largest on the local stock exchange with all Four Majors plus Macquarie included in the ASX Top10.
In a recent strategy update on global banks, analysts at Citi offered the following warning for investors: Don't Buy Cheapest Banks.
Their motivation: "Pursuing a Value strategy within the global Bank sector has been an especially disastrous strategy. Cheap Banks in Europe and Japan have got even cheaper. More expensive Banks in the US have stayed expensive. We don't expect this valuation gap to mean-revert anytime soon."
In other words: when growth is elusive, and the pressure is on, investors should adjust their strategy and focus too. Cheap stocks might be lagging for very good reason.
With yield curves inverting for government bonds, economic momentum struggling and credit growth sluggish, banks globally have been lagging the bull market. Hence the recent reset in bond markets, whereby yield curves steepened, triggered a renewed interest in bank shares around the world. This is part of the rotation into "Value" career professionals like to talk about.
But Citi analysts are not buying it. They argue valuations for bank shares should stay "cheap" because the global economy remains weak and bond yields will remain low.
In Australia, it can be argued, bank shares are not particularly "cheap", as they have benefited from the attraction of 5%-6% dividend yield in a global environment that has half of all government bonds outside of the USA trade in the negative.
But they seem "cheap" in comparison with stocks like Macquarie Group ((MQG)), Transurban ((TCL)) and Charter Hall ((CHC)); stocks that have fully participated in the share market uptrend and contributed with gusto to pushing major indices to an all-time high this year.
Yet, the October-November reporting season has left shareholders with a sour after-taste. All of Bank of Queensland ((BOQ)), Westpac ((WBC)) and National Australia Bank ((NAB)) announced a sizable reduction in their final dividends, while ANZ Bank ((ANZ)) kept its stable, but with -30% less franking. In a surprise move, Westpac raised extra capital too.
Little surprise, the local bank sector has been the worst performer of late. October delivered a general decline of -4.4% for the sector to keep the overall performance for the Australian market slightly in the negative for the month. In the words of UBS: "it appears the market is coming to terms with the outlook of decreased profitability from lower rates and increased capital requirements".
Observation number one, once again re-emphasised during this reporting season: a higher yield (as implied by a "cheaper" share price) does not make the better investment. It's usually the exact opposite.
Commbank ((CBA)) shares trade at a noticeable premium vis a vis the rest of the sector (as can also be established through its lower yield on offer) but the bank is not anticipated to follow its peers with a dividend cut at the next half-yearly results update, which will be in February.
On my own historical data analysis, CommBank's premium valuation is backed up by superior returns versus The Rest over five, ten, fifteen and twenty years. Occasionally, one of the laggards in the sector might experience a catch-up rally that temporarily pushes CBA into the shadows, but the prize for consistency and absolute outperformance inside the Australian banking sector remains essentially uncontested, on the premise we do not include Macquarie Group.
This by no means implies there cannot be more negative news from CommBank or the other banks. Far from. A recent sector update by Morgan Stanley asks the question whether Australian banks are yet again facing another period of sustained underperformance relative to the ASX200.
If investors wanted more evidence the Golden Years for banking in Australia are now well and truly in the past, Morgan Stanley's research shows banks have noticeably underperformed five prolonged times since 2000, with two of the five periods occurring since April 2015. If we are presently experiencing period number three (six in total post 2000) then the frequency is in significant acceleration.
Below is the graphic depiction of the five periods since 2000 that accompanied the Morgan Stanley research report:
What the banks have once again shown to investors is that higher yield tends to correlate with higher risk. The market is not always correct and whatever can be identified in terms of risk, it may not even impact or materialise, but there is that possibility. Investors should always weigh up whether it is worth taking the risk.
And that risk should not be solely measured in loss of capital. CommBank shares, essentially the Primus inter Pares in Australia, have done nothing but trend sideways since September 2015. Over that same period shares in Macquarie Group have appreciated by some 75%.
So for a slightly lower dividend yield on offer, backed by a superior growth profile, Australian income investors could have accumulated significantly better returns if only they weren't so afraid of paying a little more for it. Those opting for any of the "cheaper" alternatives in the sector find themselves in a much worse situation today.
So what is an investor to do who today is sitting on some cash, looking to be deployed in the share market?
My advice has been, and still is: look for Quality Yield. What exactly defines Quality Yield? Pretty straightforward: it's a dividend that is most likely to rise over multiple years ahead. Admittedly, such a proposition is probably not available at 5.5% or 6% yield, but then again, investors are less likely to find themselves confronted with capital erosion and/or a dividend cut further down the track.
The FNArena website offers forwarding looking estimates and daily broker research updates, alongside a number of other tools and services, to assist investors with their quest.
It also just so happens a few analyst teams recently made a valuable contribution as well. The property team at Morgan Stanley last week released a 145 pager on the ASX-listed property sector with the aim of identifying the best investment opportunities in the sector.
What sets this type of research apart from the usual analysis done elsewhere is that it is not solely based upon "valuation", relative or otherwise.
Morgan Stanley prefers "manufacturers" over "collectors" and "creators" over "owners", with the team labeling itself "selective with value". Identified sector favourites are Stockland ((SGP)), Goodman Group and Mirvac ((MGR)). Sector exposures to stay away from, even though they might look "cheap", according to the team, include Scentre Group ((SCG)), Vicinity Centres and GPT ((GPT)).
Investors should note Morgan Stanley analysts agree with the view that owners of retail assets look "cheap", but they still see shopping malls coming under pressure from both tenants and consumers, which implies there could be a long tail risk hanging over this sector for much longer.
Property analysts at Credit Suisse updated sector forecasts and modeling, including a new risk free rate and equity risk premium, resulting in the forecast that AREITs in aggregate are likely to generate a total return of 4.4% over the year ahead, or plus or minus the projected average dividend payout.
Sector exposures that are expected to perform better include Scentre Group, Dexus Property Group ((DXS)), GPT, Abacus Property Group ((ABP)) and Goodman Group. Note the team at CS is less worried about broader, longer term trend risks than the colleagues at Morgan Stanley.
Macquarie has compared infrastructure stocks with utilities and AREITs and concluded utilities currently offer the superior total income profile, with infrastructure and AREITs both equal second. Risk-adjusted, Macquarie believes, infrastructure offers the highest potential return. AREITs are seen offering "a balanced yield exposure".
On Macquarie's projections, utilities such as AusNet Services ((AST)) and Spark Infrastructure ((SKI)) carry the highest income potential over the next three years, but they also come with the highest correlation with the broader share market (meaning: above average volatility in share prices).
This is most likely because they offer very little (if anything) in terms of growth. It's all high yield.
Tellingly, Macquarie's favourite yield stock is currently Mirvac, as it is seen offering 4% yield growing at a sustainable 5% per annum.
Macquarie's other favourites are Goodman Group, Charter Hall, and Lendlease ((LLC)).
My recent warnings for investors:
Tickets to Conference on Agricultural and Veterinary Biotechnology
Pitt Street Research, whose work can also be found on the FNArena website: https://www.fnarena.com/index.php/pitt-street-research/, is organising its inaugural Life Sciences Conference with the focus on Agricultural and Veterinary Biotechnology.
The Conference takes place in Sydney's CBD on November 28th and runs from 8.45am till 1pm on the day. ASX-listed companies presenting include PainCheck, Anatara Lifesciences, Abundant Produce, PharmAust ltd, CannPal, EM Vision and Osteopore.
FNArena has ten tickets available for investors who'd like to attend this event at no cost; paying subscribers receive this opportunity first. If interested, send an email to firstname.lastname@example.org
This week's audio interview about portfolio rotation and what it means for the Aussie share market:
We created a YouTube channel for such interviews, which was recently upgraded (technically speaking):
Rudi On Tour In 2020:
-ASA Hunter Region, near Newcastle, May 25
(This Part Two story was written on Thursday, 7th November 2019. Part One was written on Monday 4th November 2019. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).
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