One of the biggest uncertainties hanging over investment markets currently is the trade conflict between the US and China. There are almost as many theoretical outcomes as pundits to propose them. At Fidelity International, our edge is understanding the investment merits of individual stocks rather than divining outcomes at a more macro level. While we don’t feel we have any particular insight if the trade tensions will escalate or dissipate from here, we do know that ensuing fears and sentiment will continue to impact share prices. There are two companies we like that will do well under each of the various likely outcomes.
If trade tensions abate from here, we believe that some of the market’s current negativity toward Treasury Wine Estates would reduce. We would then expect that as the current build up in inventory into luxury wines and into improved distribution arrangements in the US translate into higher cashflows, the stock’s rating will shift towards reflecting its attractive growth prospects.
Should the trade dispute escalate, we see Lynas as an ongoing beneficiary. As the only producer of refined rare earths outside of China, Lynas will become increasingly important to its Japanese, European and US customer base. This will create favourable conditions for its growth investments, along with a likely increase in pricing of its key rare-earth commodities.
Ensure enough offshore earnings exposure
The Australian economy’s prospects have improved with several positive shifts in financial conditions. These include:
- The avoidance of Labour’s proposed changes to negative gearing and franking refundability;
- The removal of APRA’s 7.25% servicing hurdle on new mortgages;
- The RBA’s recent 25 bps rate cut;
- The continuing strength of the iron ore price.
On the back of these changes, the recent declines in house prices may have largely played out for now.
Nonetheless, Australian households carry one of the highest debt burdens in the world and house prices offer very poor affordability and value. Many borrowers face increasing repayments as their mortgages shift from interest-only to amortising and wages have been stubbornly stagnant. A weaker Australian dollar means that purchases from overseas will cost more. Collectively, this indicates that the Australian consumer is not in great shape and overall economic outlook is somewhat fragile.
With this backdrop, it is important for investors to seek exposure to businesses which derive a large portion of their earnings from outside of Australia.
There are many examples across a range of sectors, but some preferred exposures for us include CSL in healthcare, Goodman Group in the property sector and Lovisa in the consumer discretionary sector.
Time to own gold stocks?
Economic theory teaches that assets can be valued by looking at the present value of the future cashflows they will generate. This makes the perceived value of gold problematic – since gold doesn’t offer rental income or operating earnings or any other cashflows.
Gold’s value is a function of its perceived scarcity and fluctuate quite significantly based on overall investor sentiment, which can make it a risky investment. Nonetheless, investing in gold mining companies is an attractive option as these companies can pay dividends, and thus are more amenable to traditional valuation analysis.
The gold price peaked in August 2011 at over US$1,800/oz. In early 2013, it fell to US$1,200, troughing at ~US$1,000 in 2015. Today the gold price is around $1,380 (as at 20 June 2019), which is the highest price in five years. This strength in gold prices most likely reflects investors’ fears around geopolitical instability, lower US interest rates, and a weaker USD. In AUD terms, the gold price is now above AU$2,000. The revenue line for Australian gold producers is strong, but what matters is margin or the gap between revenues and costs.
For a company like Evolution Mining (ASX:EVN), costs are running at less than A$1,000/oz – so at these levels the company is making 50% margins! This falls through to a dividend yield of around 2%, with the scope for this to improve if gold prices hold at this level. It is trading on a forward free cashflow yield of 9%, so while the stock has moved up recently the valuation is not yet extended.
Only invest in financially strong companies
Balance sheet structures have a large impact on the performance of the underlying equity. In an upturn, more leveraged businesses can generate outsized performance for equity holders. But leverage works both ways, and in a downturn, those same businesses can underperform their peers. Investors tend to focus more on the income statement than the balance sheet, focusing on growth in sales and earnings. However, they need to look beyond the income statement, and assess it in conjunction with the balance sheet to understand the robustness or fragility of a business.
Businesses that have funded their growth through debt are susceptible to financial market conditions when it comes to servicing or refinancing their debt. An understanding of their debt structures is crucial to understand their robustness while dealing with a change in financial market conditions. It is also important to think about the sensitivity of the business’ equity to the business cycle, as more debt will enhance this.
It would benefit investors to understand how much leverage exists in the holdings of the funds they invest in, and what the terms of that debt is, as this will have a major impact on equity returns through the economic cycle.
Investors should also be wary of non-traditional forms of financial leverage which can also diminish value, for example contingent liabilities and performance bonds. When these are coupled with operational leverage the outcome can be catastrophic.
Look for stocks that generate cash and pay dividends
Accounting earnings of a company often are open to interpretations, which gives rise to the saying “cash is king”. The ideal investment is one which generates significant cash and is also fast-growing. But in the prevailing market environment, these businesses have in most cases been bid up to quite stretched stock valuations.
Thus, it pays to look around for companies that are unloved by the market due to their subdued growth prospects, but nevertheless generate attractive levels of cash. These are often found in “old economy” or “disrupted” industries such as media and publishing. Opportunities exist where a sound but slow-growing business has been overlooked by the market. Investors need to exercise care that they are not chasing a value trap, which cashflows will spiral down through time.
One of these is IVE Group (IGL). IVE publishes catalogues and collateral for companies such as Coles and Westpac and for the Australian government. It has reduced the level of price competition in its industry by also offering customers add-on digital services such as personalised coupons and emailed offers. Since the market has determined that “magazines are dead” the stock has felt little love from the market. Its free cashflow yield at 8% is in-line with its PE of only 8x!
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