Join Rudi’s Journey: Let’s Not Go Overboard

This story features ORIGIN ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: ORG

By Rudi Filapek-Vandyck, Editor FNArena

The Governor at the Bank of Canada, Mark Carney, is not necessarily the best central banker of his time (that will be for historians to decide in the future) but Canada's ex-Harvard and ex-Goldman Sachs Governor certainly is one of the most outspoken among peers post late 2007, when he was appointed for a seven year term.

Carney has become some kind of a cult figure among those financial experts and commentators worldwide who remain skeptical about what is happening in the world. Contrary to, for example, Glenn Stevens in Australia, BoC's Carney doesn't provide hints in between paragraphs, he simply tells it like it is. And it ain't always what authorities and investors elsewhere would like to hear.

You probably instantly grasped where Carney's cult-popularity stems from. (Carney enjoys an impeccable reputation for his show of steady hands when steering Canada through the insecurity of 2008-2009).

Under the assumption that Carney's direct influence is stretching as far as the regular market views published by the BoC, I thought it appropriate to pause and reflect upon what the BOC's Monetary Policy Report had to say earlier this month. After all, January has opened up with a big jump for equities around the globe not seen since the mid-nineties and many a market commentator has subsequently rediscovered his enthusiasm to steer investors back into the market. It's easy to get distracted by day-to-day movements and commentary, not to mention that creeping feeling there's a train about to leave the station and available seats are limited.

Conclusion number one, according to said Monetary Policy Report, is that the recession in Europe will be long and deep, not shallow and quick. There's a negative tri-factor in play; tighter credit plus additional austerity plus pressure on confidence.

Conclusion number two is that modest growth is about the maximum the US economy realistically can hope for.

Conclusion number three, which I personally regard as the most important one, is that the overall impact from the fall-out in Europe has yet to move into its next stage, wherein reverberations from tighter credit and increased funding costs will be felt across the globe, resulting in an additional drag on growth.

Remember, the European banking system is four times the size of its peer in the US and those banks are important intermediairies for global trade finance and business credit. Which is probably why the BoC predicts business confidence in the rest of the world as well as business credit and investments are yet to feel the full impact from Europe's banking stress. (Note: contrary to general commentary, the current crisis is not about Greece or other governments' debt levels, it's about European banks' endangered capital and balance sheets).

Commodity analysts at UBS last week issued an explicit warning the global economy might well be on its way to a "deflationary bust", triggered by three major developments; less credit creation, capital flowing back to the US and increased credit stress for traders and businesses around the world. In the analysts' opinion, European banks play a vital role as the global conduit for funds flows between the US and Emerging Countries and deleveraging at troubled European banks therefore threatens to exacerbate capital flight from these Emerging Markets.

Bottom line: if these commodity analysts at UBS (whose report, though written with "conviction", does not represent the official in-house view at UBS) turns out correct, this will be extremely negative for industrial miners and other risk assets.

Call me paranoid if you like, but I don't think the Bank of Canada and (some) commodity analysts at UBS are the only ones watching the European banking stress, and its international repercussions, with heightened interest. I think this is why the European Central Bank late last year embarked on its own version of Quantitative Easing and why the US Federal Reserve last week announced its intention to keep interest rates at exceptionally low level until late 2014.

Think about this for a few moments, while equities and commodities are enjoying an apparent bout of optimism and commentators and economists feel more confident that the US economy is now on firmer footing, the world's mightiest central bank adds up to 18 months to its promise to keep the cost of debt at ultra-stimulatory level while also signalling the bar to employ QE3 (in essence: even more added liquidity) really isn't that high.

Makes sense? Only if we take note of the predictions and concerns at the BoC and inside UBS.

Let me be clear on this matter: I don't think anyone actually knows what exactly lies ahead for the global economy and financial markets this year. There are too many moving factors and unprecedented circumstances in play that make all kinds of scenarios possible, both good and bad, including some extreme outcomes.

What is possible, however, is to make some broader predictions about the world in general; developed economies will grow at slow speed, there's still too much debt, more austerity is coming our way, we will not see a return of 1982-2000 or of 2004-2007 anytime soon.

For years I have been making references to the 17 years between 1964 and 1981 in that I believe this period remains the most accurate guide history has on offer for investors post 2007.

To refresh everyone's memory, I have included my favourite chart for the period:

When confronted with this chart, most investors feel inclined to draw the conclusion that "trading" is the only viable way to participate in the share market, but this is, of course, not true. Solid, dividend paying industrials of the kind I described and named in my e-booklet "The Big De-Rating. A Guide Through The Minefields" are ultimately the best friend of EVERY investor with a long term portfolio.

The problem such investors are facing since late last year is that by now most defensives are fairly priced, if not fully priced and thus making a defensive choice today might not be as easy and straightforward as twelve months ago. For what it's worth, here are a few ideas and thoughts that come to mind:

– if you are a long term investor, don't give up on your defensive exposure, unless you want to skim some of the fat or get rid of the lesser quality ones. Remember: you do not necessarily care about what happens tomorrow, you care about your returns in years from now. There's enough academic research around to back up my own research that, in the longer run, virtually nothing beats accumulating solid, growing dividends (Remember "Rio Tinto versus David Jones")

– I can see the rationale to add more risk, as undervalued risk assets can potentially yield high returns in a short time span. But don't go overboard. All that is happening right now in share markets is a "correction" in the relative valuation gap between defensives and cyclicals. The gap had become too wide. Economic data and investor sentiment permitting, this process can last for a while and it can even take the form of a big rally under a positive scenario. If your defensives get left behind, don't panic, at some point there will be swings back the other way and you continue to enjoy growing dividends (in case of any doubt: look at the chart above)

– For those looking to add defensive exposure, UBS analysts recently concluded infrastructure stocks still offer solid, growing dividends combined with relatively robust growth and reasonable valuations. UBS made a comparison on earnings and dividend forecasts four years out between infra stocks and defensives in general. Its top 10 of best value opportunities is (in declining order) Transurban ((TCL) number one, followed by Australian Infra ((AIX)), Brambles ((BXB)), Origin Energy ((ORG)), Goodman Fielder ((GFF)), Woolworths ((WOW)), Amcor ((AMC)), Australian Pipeline Trust ((APA)), Coca-Cola Amatil ((CCL)) and Wesfarmers ((WES)).

– There are still stocks under the label of "all-weather performers" that appear to represent good value. I note, for example, one of my all-time favourites Fleetwood Corp ((FWD)) is back at around $12, which is a much better entry price than the $13 or $14 witnessed last year. I still like McMillan Shakespeare ((MMS)) and Hansen Technologies ((HSN)) though the latter appears to have gone ex-growth for one year which may still translate into more weakness. Breville ((BRG)) remains a solid opportunity but the share price rallied this week. Amcor ((AMC)) has the spectre of a slowing European economy in front of it, which might weigh on sentiment, though earnings growth should remain in place.

One other all-time favourite whose share price has lost some territory recently is food supplements and vitamins producer Blackmores ((BKL)). Everyone who knows this stock knows it has the tendency to be overbought at times and this seems to have been the case again in March last year when it rose to $32. More recently the share price has retreated from $30 to $28. In my view, Blackmores looks better value every day.

I still like Ardent Leisure ((AAD)). Growth should return in FY13 when the forecast dividend will yield in excess of 12% (not franked). And I agree with UBS, I should have mentioned Transurban ((TCL)) more often than I have done in years past.

Note: with the exception of Ardent Leisure, all these stocks I mentioned (ex the UBS list) have provided their shareholders with capital protection and a positive return post 2007. Many of my personal favourites from last year are too highly valued to be comfortably bought at these levels.

Another segment of the share market that continues to deserve investors' attention are the service providers to energy and mining companies. The above mentioned Fleetwood comes with lesser risk, but others such as Mermaid Marine ((MRM)) and Mastermyne ((MYE)) offer more upside potential.

I strongly recommend all subscribers read my e-booklet "The Big De-Rating. A Guide Through The Minefields" in order to achieve a better understanding as to why every long term investment portfolio should contain a big chunk of "all-weather performers".

If you are a subscriber and you haven't received your copy yet, send an email to info@fnarena.com

(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.)  

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website. 

P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

 

Click to view our Glossary of Financial Terms