This article by Guy Carson was originally published in the Weekend Wealth section of The Australian under the title “Time to plan for recession as household debt crimps spending”
Back in 2007, a US economist called Edward E. Leemer published a paper entitled “Housing IS the business cycle”. In this paper he studied the causes of every US recession since World War 2, of which there had been 10. What he discovered was that 8 out of the 10 were preceded by substantial problems in housing and consumer durables.” The only two US recessions that are exceptions to the above were the end of the Korean War in 1953, caused by a decline in defence spending, and the 2001 “Tech Wreck”. As the paper was written in 2007, we can now improve the success ratio to 9 out of the last 11 recessions following the 2008 recession, something that Leemer warned about.
When one reads this paper and looks at the current economic environment in Australia, it is hard not to get nervous. Recently, the retail sector has seen a significant selloff and whilst many observers point the finger squarely at Amazon, we believe there might be more at play. As a case in point, the recent downgrades from the two largest car retailers in Australia (AP Eagers and Automotive Holdings Group) tell an interesting story. As far as I’m aware Amazon does not sell cars and yet sales on a national level are falling. What is causing this? Well, Australia has the second most indebted consumer in the world behind only Switzerland with respect to Household debt to GDP (chart below). The rise in household debt in this country has pushed the level above what was seen in places like Ireland and Spain prior to the Global Financial Crisis. Recent out of cycle interest rate hikes from the banks combined with record low wage growth has put significant pressure on this highly leveraged position.
Source: Bank of International Settlements
High debt levels mean the consumer is highly sensitive to small changes like we have recently seen. As a consequence we have seen a fall in car sales on a national basis led by falls in Western Australia and Queensland. AP Eagers indicated that sales were impacted by a 5.9% fall in Queensland whilst Automotive Holdings stated that a 3% fall on the east coast had “reduced the capacity of east coast earnings to provide cover for WA”.
In addition to falling car sales we had construction data out for the first quarter of 2017 and we had the first signs of the residential construction boom slowing. The fall in residential construction for the quarter was 4.7% and was the largest such fall in over 15 years. The fall was driven by a 14% fall in Queensland and whilst this was potentially cyclone impacted, the increasingly oversupplied Brisbane apartment market appears to be having an impact. This fall in residential construction combined with sharply falling car sales ticks both of Leemer’s boxes and suggests Queensland may well be joining Western Australia in a recession.
Whilst problems are evident in Queensland and WA, it is probably too early to have the same concerns for NSW and Victoria but the overall economic outlook is slowing. So with that in mind how should one position portfolios? Well, for starters are a long list of companies and sectors to avoid. The three stand out to us as most vulnerable are:
Anything consumer orientated. With record high household debt and record low wage growth, retail activity will remain subdued at best. Companies in this category include the likes of JB HIFI, Harvey Norman, Nick Scali and the above named car retailers.
Anything finance related. High household debt makes consumers more vulnerable to both a slowing economy and interest rate changes. Whilst we do not expect the RBA to raise rates we note that increasing regulation and offshore funding markets could lead to further out of cycle hikes. Companies that are vulnerable here include Credit Corp, Pioneer Credit, Money 3, Flexigroup as well as the banks.
Companies tied to residential construction. Ultimately residential construction will fall; it has fallen in WA and is starting to fall in Queensland. Companies exposed here include Adelaide Brighton, Mirvac, Leadlease and Finbar.
The question becomes where to hide. If we do have a recession, very few stocks will do well. In order to avoid cyclical weakness it is important to look for industries that are going through structural change. The three most obvious examples to us are:
The technology sector. Technology is enabling companies and individuals to become more productive, to do more with less. Australia is home to a number of software companies that are world leading in particular niches. Examples of this include Altium, Gentrack, Hansen Technologies and Integrated Research. As these companies are global players they will benefit as well from a falling Australian dollar.
Healthcare. Ageing populations globally leads to natural demand growth and thankfully Australia is home to a number of world leading companies such as CSL, ResMed, Ramsey and Cochlear. Again, these companies would all benefit from a falling Australian dollar.
Truly counter cyclical companies. An example of which would be shareholder litigation companies such as IMF Bentham. In times of stress, fraud and misleading statements tend to be exposed.
The current consumer strike is sounding warning bells to us. The economies in Western Australia and Queensland appear to be in or heading for recession, it’s only NSW and Victoria (or more accurately Sydney and Melbourne) that are holding the economy up. Whilst we have no perfect insight in the future, we believe that now is the time to be selective with your investments.
DISCLAIMER: Guy’s portfolio currently includes the following stocks mentioned above: Altium (ALU.ASX), Gentrack (GTK.ASX), Hansen Technologies (HSN.ASX), Integrated Research (IRI.ASX), CSL (CSL.ASX), ResMed (RMD.ASX), IMF Bentham (IMF.ASX).
This week Robert Swift takes a look at how growth and value strategies have performed historically and how he sees them performing going forward.
There is no “right way” to invest. Many approaches can work and many styles or philosophies (growth, small cap, value, contrarian etc) all have their moment in the sun. Some strategies work better than others in that they are both less volatile (work more often) and offer more opportunities to the active manager in so far as they better identify high stock return dispersions = the survivors win big and the losers lose all.
The strategy which seems to work best and offer the most opportunity for active management is value.
This value bias however comes at a price. While value investors expect to have the last laugh they sure miss out on a lot of laughs in the meantime. Put another way there is ultimately a risk and return benefit to being careful about the price you pay for investments, and for wanting dividends, but you do miss out on bragging rights at the cocktail party in that you probably don’t own a ‘sexy stock’.
At the moment on a global basis, value is not in the sun but in the shade. We show the extent to which growth is currently more popular than value right now in the chart below. This traces the compound return of the S&P global growth index (blue) and the global value index (orange) in the last 10 years.
Growth is ahead by a handy amount and so one would prefer to use a growth approach right?
Probably wrong – you should never drive looking in the rear view mirror.
The logical conclusion actually, is that the value risk premium is now much higher than the growth risk premium. In other words, value stocks are more likely to outperform from here given relative valuations. The time series returns are starting point dependent so only going back 7 years would show value outperforming. It is this starting point dependency that illustrates the mean reversion of the styles.
Going back 20+ years growth wins quite handily with about a +1% pa excess return over value.
We try to show the benefits of having a value bias in the bar chart graph below which sorts stocks by P/E ratio and then their subsequent returns. It doesn’t look sensible to buy high P/E stocks and yet that is what growth stocks are now – on high P/Es.
Value investing is possible because capitalism allows companies to enter and leave businesses. New capital will flock to industries in which there are above average returns on capital and will leave those with below average returns. Growth stock industries attract new capital which drives down returns or causes enormous cash investment to remain ahead of the curve. In such cases there is little room for dividends which are a large part of the total return equation. Value stocks tend to be the opposite. Investors like to be with the crowd and so tend to ‘flock’ to growth stocks as they run up. It can all end in tears. The challenge is to remain immune from the fear of being unpopular and even looking stupid as the growth party rocks on.
More subtly some investors argue that it doesn’t matter whether growth or value wins. It is often beneficial to use both approaches with an active manager in each, since the return series are diversifying. As long as both styles avoid stock disasters, the combination of styles can be powerful. More on that in later articles.
The extent to which growth and momentum investing has gained an irrational upper hand can be seen in the following extract from a recent Bloomberg note.
“Investors may have borrowed money to chase the rally in the Sexy Six (Amazon, Apple, Facebook, Google, Microsoft and Netflix), resulting in a record amount of margin debt in March, Ned Davis, a strategist at the name-sake research firm, writes in a note. * Six stocks up 9.2% on a cap-weighted basis from March 1 to May 19, versus -1.8% for the rest of the S&P 500 * “The concentration in this bull market has been extraordinary, and that could be a sign of speculation and the type of narrow leadership seen in the late phases of bull market.” – Bloomberg
Value investing tends to come “at a price”. That is there are certain consequences of using such an approach and while the dividend yield is higher and the asset backing security greater, there are consequent sector exposures and periods of doubt or underperformance. We list the major characteristics of value styles below.
They tend to perform better in economic uptrends with rising interest rates. Are we there now?
Stocks usually more cyclical in nature. Other investors underestimate the earnings leverage and a change in fortunes can run for many years in a positive way.
Sectors favoured tend towards banks, insurance, telecoms, construction and utilities. These are not ‘sexy’ and the cocktail party chat is limited! It was actually the GFC and the subsequent years of enormous bank penalties and restrictions, that hurt a large part of the value index return. That period is likely to be over.
Attraction of low PE investing is that idiosyncratic risk or cross sectional vol of universe is greater. That is stock picking is more rewarded. (As written in Anna Karenina – All happy families are alike but all unhappy families are unhappy in their own way – who knew Tolstoy could be quoted with reference to value investing)
It is the reinvestment of the higher dividends that compounds up. Dividends are proof of cash flow.
Value tends to perform better in periods of higher M&A as it is the lower rated stocks in any given sector that tend to be acquired.
Tends to be characterised by higher dispersion of return – the stocks have more volatile beta, higher financial gearing and some of the value stocks never make it back since their businesses are fundamentally obsolete. These are known as value traps and the usual story is that of buying a horse drawn carriage in 1920 as they became cheaper and cheaper. There was no price at which it was right to invest – the industry was dead.Some would argue the car industry is dying now as we move to driverless cars. We will see.
To avoid value traps it is better to combine a low PE strategy with positive earnings revisions or some evidence of management and strategy change such as disposals or acquisitions and we do use this in our fund management research. Cheapness alone doesn’t do it. It is “Cheapness AND Change”.
Current low P/E stocks where we see change, and which we own are:
Valero – The world’s largest refining company benefitting from lower feedstock prices and the shale boom in the USA.
Glaxo Smith Kline – A UK based leading global drug company under new direction as it seeks to emphasise its consumer products division, and to get a better payback on its high R&D budget.
Cisco – A USA based company shifting from a dependency on hardware sales to a service and software business model.
Guy Carson takes a look at the three major players in the Australian insurance space. How do they work and is there value to found in QBE, IAG and Suncorp?
Australian Insurance: Is there quality and value?
Guy Carson
The Australian General Insurance landscape is dominated by three players: IAG, QBE and Suncorp. Over the last decade, investors in these companies have seen significantly different outcomes. In order to understand why, it’s important to look at how insurers make money and how they can insulate themselves from disasters.
How does an insurer make money? The below graphic from IAG shows us the basic business model.
Source: IAG
Essentially, an insurer receives income from premiums and investments and in turn faces claims as well as various expenses. The difference between the two becomes the profit.
The confusing thing for investors is that whilst the business model is simple, the terminology used can be confusing. For example most insurance companies quote three different numbers when it comes to premiums:
Gross Written Premium (GWP) = the total amount received from customers for the payment of their insurance policies.
Gross Earned Premium (GEP) = When calculating results for the financial year only include the portion of policies up to June 30.
Net Earned Premium (NEP) = Gross earned premium minus reinsurance costs.
For earnings and valuation purposes it is the Net Earned Premium that matters although it is important to keep an eye on Gross Written Premium to see how the company is growing.
From Net Earned Premium we can then subtract the claims received as well expenses incurred in the course of business to arrive at the Underwriting Profit (or Loss). The first important step in choosing an insurance company is ensuring it makes an Underwriting profit.
Source: IAG
The great thing about owning an insurer though is that profits can be boosted by investment. The company holds a float of technical reserves (or policy holder’s funds) and can use these to generate further income. This is often referred to as an earnings multiplier.
Source: IAG
Furthermore the company can invest shareholders’ funds and gain further income that way.
Source: IAG
So that’s how the business model works. The question is how do we analyse whether an insurance company is performing well? For that there are a few simple ratios that help us understand how the underwriting business is performing. These are:
The Loss Ratio (or Claims ratio) which is the ratio of the net claims expense to Net Earned Premium; in simple terms the percentage of claims they received the premiums they earn.
The Expense Ratio which is the ratio of Underwriting expenses to Net Earned Premium; In simple terms the amount the company spends on its underlying expenses in order to run its business.
These two ratios together equal the Combined ratio. The combined ratio plus the investment returns earned give the Insurance Profit Margin. This margin describes the profitability of the business.
Source: IAG
So how do Australia’s general insurance companies stack up on these metrics? The table below is a summary of the most recent annual results from QBE, IAG and Suncorp.
Source: Company filings & Thomson Reuters
In the table we have separated the expense ratio into two parts for QBE and IAG – commissions and other expenses. This shows one of the critical differences between the QBE model and the other players. Companies with stronger brands tend to pay away less in commissions to sell their products. IAG in Australia and New Zealand has a number of well-known brands (think NRMA, CGU and more recently Coles Insurance). In their expansion overseas QBE took a strategy of rolling up smaller players, in doing so they have ended up with a significantly higher commission base and hence higher expense base. This additional cost pushes up their expense ratio and makes the company less profitable.
In the early days of the expansion, the company appeared to be doing well despite this higher expense base. Their Insurance Profit Margin rose strongly through to 2007 as can be seen below. The drivers included increased premiums, increased investment returns and a benign claim environment.
Source: Company filings & Thomson Reuters
IAG on the other hand had a different experience, after a difficult period from 2006 to 2008, the company has seen a strong recovery in their performance. The key reason the company struggled in that three year period was a rise in claims with the loss ratio rising above 70% as seen in the chart below.
Source: Company filings & Thomson Reuters
QBE saw claims rise significantly from 2008 to 2011 and the share price followed suit with a steady decline. One of the problems that QBE has is that its expense ratio is consistently higher than IAGs (due to the reasons discussed above). This means that its profit margin is more sensitive to changes in claims. In our opinion, the simplest way to define quality in Insurance companies is those with lower cost bases and lower expense ratios as they can withstand disasters more effectively. On this basis, we would say that IAG is the quality insurance name listed in Australia. Particularly given that after the difficult 2006-2008 period, the company came out with a renewed focus on costs and has reduced its expense ratio significantly since then.
Source: Company filings & Thomson Reuters
Of course, defining quality is only part of our investment process. We also have to take into account valuations as well. To this end, one challenge facing Insurance companies is the current low interest rate environment. Low interest rates mean the return on both the policy holders and shareholders’ funds are now lower than previous and hence the multiplier effect is no longer as strong. This suggests that insurance margins moving forward are unlikely to reach the highs of yesteryear. As a result it is also unlikely the shareholder returns of the past will be repeated.
Everything has its price though the question remains whether there is value right now. To that end we believe the market is currently pricing a solid recovery for QBE on the back of improving signs in its US business with the company trading on 13.1x forward earnings with expected growth this year of over 20% and further growth in FY18. The company can’t afford for anything to go wrong in this recovery. Meanwhile, IAG is priced fairly fully at 17.3x with earnings growth expected over the next few years of around 10% (after stripping out the impact of the Berkshire Hathaway quota share arrangement). Any increase in claims will likely weigh on the price. So in our opinion there appears to be no obvious value at the moment; however it is worth keeping an eye on the sector as share prices tend to overreact on events outside of the companies control such as weather related events. When share prices correct due to these events, they can quite often be solid longer term opportunities.
This week we bring to you yet another piece by friend of TAMIM Sam Ferraro of independent financial education firm Evidente. Given Guy Carson’s recent commentary surrounding housing and building approvals we thought it was an important read.
This article was originally penned on February 16, 2017.
Dwelling investment represents one of the highly cyclical components of aggregate demand. Since the inception of the National Accounts in the late 1950s, investment in housing has been subject to numerous cycles, but in the past dozen years the cycle has become more extended and less volatile (see chart below). At present, total dwelling construction accounts for 6% of GDP, a peak reached only five times in the past sixty years. Usually, housing activity of this scale has reflected overbuilding, and subsequently been followed by a sharp downturn, including: the 1980s, mid-1990s, early 2000s and mid-2000s.
NEW DWELLING INVESTMENT CLOSE TO A RECORD HIGH
What is particularly unique about the housing expansion since 2012 is the composition of dwelling investment. The GDP share of renovation activity – ‘alterations and additions’ – remains low by historical standards at around 2%. This was the basis for Evidente suggesting in prior posts that the renewed growth in house prices this time didn’t reflect an emerging property market culture, like that which prevailed in the early 2000s, when renovation activity lifted to 2.6% of GDP. Many home-owners became DIY experts over this period, and the turnover of the housing stock lifted as owner-occupiers sought to renovate and sell quickly at a handsome profit. Rather, new dwelling investment has underpinned the current expansion, which has lifted to 4% of GDP, its highest level since 2000/01 (see chart).
AUSTRALIA’S APARTMENT BOOM
The second dimension of Australia’s housing revolution has been a shift towards higher density living; Australia’s apartment and townhouse boom. The number of residential building approvals for higher density dwellings is now comparable to that for detached houses, at between 110k and 120k per annum (see chart).
In its February Statement of Monetary Policy, the RBA notes that within the higher density segment, there has been a shift towards apartment blocks with four or more storeys (see chart).
Australia’s housing revolution towards higher density living has been felt across the entire eastern border; the number of residential building approvals for apartment blocks and townhouses has posted strong growth since 2012/13 across NSW, Victoria and Queensland (see chart). In the past year however, there has been a substantial drop in high density approvals in Queensland and Victoria, probably reflecting the tightening of bank lending standards to housing investors and lower price growth. The RBA notes that the boom in apartment construction has been particularly concentrated in inner city Brisbane and Melbourne, which make these cities vulnerable to rising risks of over-supply emerging.
According to the RBA, the number of cumulative apartment building approvals in the three years to 2015 added around one third to the stock of apartments in both inner city Brisbane and Melbourne, but less than one-fifth in inner city Sydney. These divergent trends probably reflect the relative scarcity of available land for development in inner city Sydney.
WHY THE SHIFT TO HIGHER DENSITY HOUSING?
Higher population growth
A lift in population growth in the past decade has supported the dwelling investment cycle. Year on year growth in the population has remained above 1.4% for much of the past decade (see chart). This follows a fifteen year period in which population growth typically was below 1.2% pa.
Evolving consumer preferences towards more affordable living
Higher population growth can explain some of the shift towards higher density living thanks to land supply constraints, which have been associated with higher prices for blocks of land and detached houses. This has induced a shift in consumer tastes towards apartments, which use land more intensively and are therefore more affordable than detached houses.
Limits to the urban sprawlGiven the topography of Australia’s major cities, there are physical limits to further urban sprawl. Consequently, there has been an increase in the availability of former industrial or brownfield sites relative to urban fringe or greenfield sites, which are mostly used for detached housing.
Australia’s low urban population density slowly catching up to the rest of the world
Despite the shift towards higher density housing, Australia’s urban population density remains amongst the lowest in the world, which reflects postwar policies designed to encourage construction of detached housing on suburban land blocks – particularly for war veterans and their families – and the culture of aspiration for a house on a quarter acre block (see chart).
AUSTRALIA’S HOUSING REVOLUTION – HERE TO STAY
Evidente believes that developments that have led to the shift towards higher density living are likely to persist over the medium term: limits to further urban sprawl, shift in preferences to the convenience of living close to employment centres, Australia’s still low population density and the waning aspiration of owning a detached house on a quarter acre block.
Given the topography of cities such as Melbourne and Sydney, there are limits to which the urban fringe can further expand, not to mention the high transport infrastructure costs associated with developing greenfield sites that are more distant from the city. The aversion of Australia’s governments to lift debt levels or raise tax rates to fund infrastructure has seen a rush of sorts to sell or lease government assets. For instance, the Victorian government last year announced the long-term lease of the Port of Melbourne, with the proceeds linked to the replacement of around 50 railroad crossings across metropolitan Melbourne.
The growing demands of white collar occupations are such that many workers in these roles will want to continue to live close to employment centres, in addition to the convenience and diversity of choice associated with living in or close to the inner city.
Australia’s population density remains low by international standards. The scope for Australia’s capital cities to accommodate a growing population and increase population density probably depends in part on an easing of planning laws that allows higher apartment towers to be built across metropolitan areas.
The substitution effect from detached housing to townhouse and apartment living is expected to continue. Notwithstanding the risk of a correction in house prices, the average price of residential land and detached houses is likely to remain high, encouraging people – particularly young people – to live in more affordable, higher density housing than their parents were accustomed to. Against the backdrop of the shift that has already been occurring, the aspiration to own a detached house with a good size backyard on a quarter acre block is not ingrained in Australian culture as it once was.
INVESTMENT IMPLICATIONS – THE LONG VIEW…
Planning laws have promoted the development of apartment buildings and other high density dwellings along major roads and railway lines, that have easy access to public transport. But the demand on existing infrastructure is such that congestion has continued to increase. Traffic congestion remains a political hot potato for Australia’s federal government, as well as state governments, particularly in the two most populous states, NSW and Victoria. In addition to the removal of 50 railway crossings across metropolitan Melbourne cited, a number of other transport infrastructure projects are underway, including the construction of Melbourne’s metro tunnel and the widening of Transurban’s City Link.
Evidente believes that the two listed stocks most leveraged to the construction of infrastructure projects designed to ease traffic congestion are toll road operator, Transurban, and Downer, which generates over one-third of its revenues from its rail and transport services divisions. Downer has lifted its operating profitability in recent years to over 20%, continues to trade at a discount to the broader market, and has a sound balance sheet with a gearing ratio (which includes off balance sheet debt) of less than 15%.
Hardware retailers such as Bunnings might need to modify their product range over the medium term, with the growing army of apartment dwellers presumably having less need for garden appliances and power tools. Moreover, there is less scope for apartment dwellers to engage in DIY renovation than those living in detached houses.
…BUT DON’T FORGET THE CYCLE
Despite the prospect that the structural shift towards higher density housing will continue over the medium term, booms and busts around the new normal are inevitable. As cited above, new dwelling construction remains close to a record peak of 4% of GDP. The RBA has already warned about the growing risks of an apartment oversupply emerging in inner city Melbourne and Brisbane. By late 2016, half yearly growth in inner city apartment prices in Sydney, Melbourne and Brisbane had trended down to zero (see chart).
If conditions in these markets deteriorate substantially, banks would likely experience more material losses on their development lending than on their mortgages. Development lending is typically associated with a higher default probability and higher loss given default than on their mortgage lending for apartment purchases. Nonetheless, banks’ aggregate exposures to inner city apartment markets- particularly in Sydney – are greater through their mortgage lending than via development lending (see chart). The aggregate dollar value mortgage exposure translates to 2-5% of banks’ total outstanding mortgage lending to inner city Sydney, Melbourne and Brisbane.
Australian mortgage lending has historically been profitable due to low default rates – around 1/2 per cent – and high levels of collateralisation. Price growth of inner city apartments in Sydney has been strong in recent years, so that a large price fall would be necessary for banks to experience big losses due to lower loss given default assumptions. The buffers are smaller for Melbourne and Brisbane because capital appreciation in apartments has been subdued. The RBA estimates that combined inner city apartment values across Sydney, Melbourne and Brisbane would need to fall by 25% or more before banks started to incur significant losses.
In its quarterly update this week, the CBA showed its exposure to apartment developments by city, which amounts to a little over $5 billion in aggregate. Sydney apartments represent 60% of its exposure where the buffer is larger, while Melbourne and Brisbane in total account for a little under 30% (see chart). The total loan to value ratio of 60% is conservative and the CBA indicates that it has lowered its share of foreign pre-sales.
Although the P/B discount that banks trade on relative to industrials has narrowed in recent months, it remains high by historical standards (see left panel below). The sector’s ROE has dropped in part thanks to de-gearing associated with a lift in loss absorbing capital buffers, but the ROE prospects for the industrials universe have deteriorated by more (see right panel).
Evidente is an independent financial consulting firm managed by Sam Ferraro that delivers innovative financial advice to wholesale investors, including active long only funds, hedge funds, pension funds, and sovereign wealth funds, in Australia and globally. Drawing on academic research in asset pricing, behavioural finance and portfolio construction, Evidente provides wholesale investors with commercial solutions to stock selection and asset allocation decisions across equities and other asset classes.
Sam writes as a freelance journalist for The Age, Sydney Morning Herald and Australian Financial Review, was a member of the advisory board of API Capital, teaches business finance and international finance courses to undergraduates at RMIT, and most importantly Sam is a well respected source of information and friend of TAMIM.
Scott Maddock, portfolio manager for the TAMIM Australian Equity Income IMA, takes a look at the trade-off one must account for when aiming to generate income from an equity portfolio. He takes a look at two stocks held to deal with exactly that.
Income vs. Capital return – managing the trade-off in an income portfolio Scott Maddock CBG Asset Management
Source: CBG Asset Management
We can deliver income in a portfolio both by crystallising capital gains (selling securities at a profit) and by investing in high yielding securities. When building an income portfolio, we aim to balance investing in higher yielding securities against those with the possibility of growth in value. Few strongly growing companies pay a high dividend – preferring to reinvest capital back in to the business. This grows value but doesn’t pay cash to shareholders. The obvious step for an income portfolio is to focus on high yielding but lower growth companies. However, this ultimately results in low total returns to investors as;
Those companies often underperform the overall (growing) market.
Risk is higher due to excessive concentration in similar sectors / businesses.
Interest rate sensitivity is higher – demonstrated last year when the market withdrew the favoured status of property, utilities and infrastructure.
Our approach therefore has been to build a portfolio which has a yield higher than that of the broad market but also holds shares in companies capable of growing returns or asset values.
This provides the potential for a higher total return while ensuring the income stream generally exceeds that available from cash and interest rate securities. The trade-off means we hold some stocks with high yields, some with low yields but good earnings growth and some which fit in the middle of both ranges.
A fine example of this trade-off is the Bank sector. Banks have long been a no-brainer for investors looking for tax effective income (fully-franked) and capital growth Historically, high returns on capital, strong credit growth in the economy and the ability to restrict cost growth to a lower rate than revenue growth supported the sectors total return. Even with a step down in credit growth post the GFC, the banks have outperformed. Credit growth remained solid, reduced competition supported net interest margins and lower credit growth allowed the banks to increase dividend payout ratios. However, capital requirements have now risen, reducing the sustainable payout ratio for a given level of growth. Dividend payout ratios look stretched for NAB and Westpac suggesting little dividend increase is likely. We expect further slowing in housing credit growth and, combined with factors such as the bank levy, the result will be slower earnings and dividend growth. The sector has therefore become less attractive.
This is the end (?) of a trend which has been dominant in the Australian investment market since the early 1990’s. The implications are that we need to look further afield, to build a portfolio of investments intended to deliver a solid total return while also paying a level of income. Clearly current interest rate levels are not sufficient to deliver a meaningful income from cash, term deposits or longer term bonds. Bond rates are below 3% while shorter term rates are below 2%.
Two stocks we currently include in the portfolio which offer a bit of both income and capital growth potential are Charter Hall Group (CHC.ASX) and Regis Healthcare Limited (REG.ASX);
Charter Hall is a property funds management business with a successful track record of fund expansion and performance delivery. CHC shares are currently trading on a 12mth dividend yield of 5.2% (unfranked) while delivering strong earnings growth as commercial property values remain strong and demand for professional management of property portfolios drives increased funds under management. CHC also co-invests in the funds and so has a focus on increasing asset values as well as maintaining income levels.
Regis Healthcare is a high-quality operator of Aged Care facilities. Share prices in the sector have been depressed by changes to government funding formulae however REG has been less affected by these changes than the market expected. REG shares are currently trading on a 12mth dividend yield of 4.8% (100% franked) while maintaining a strong outlook for earnings growth in coming years.
Source: CBG Asset Management
