Risk on / Risk Off - Diversification is key in volatile markets.

Catherine Allfrey

Wavestone Capital

As we look forward into 2019, conditions for equity investors remain mixed.  Global growth has been slowing with rising US interest rates, trade wars and Brexit. Whilst domestically the economy has performed better than expected this year, the tightening in lending standards is impacting the indebted consumer and house prices are falling.  The political and regulatory uncertainty around key sectors such as financial services and electricity is also leading to investor nervousness.  The pullback in equity markets in the last quarter has been sharp. 

During conditions like we are experiencing, diversification of risk across the portfolio is important. That means ensuring your portfolio is adequately diversified and equipped to handle many possible scenarios. We maintain this diversification within an equity portfolio by holding both defensive growth and more cyclical growth stocks. In our Christmas Cracker for Livewire, we share with you a couple of examples of companies we believe are likely to grow faster than the market but also offer a level of diversification to different market conditions.

Defensive growth: Transurban. (TCL:ASX)

Transurban owns the vast bulk of spare road capacity within Australia’s fastest growing and most congested cities (Melbourne and Sydney). With highly congested free alternatives, population growth drives strong traffic growth for the Group’s roads which when combined with real increases in tolls, delivers a stable and growing revenue stream.

Transurban’s most recent acquisition, Westconnex, while appearing fairly priced, cements its position as the largest owner and developer of toll roads in Australia and ideally positioning it to work with Governments to negotiate further enhancements to the road networks in which it operates. These negotiations and unsolicited bids have added significant value to Transurban’s portfolio over time at less risk than would be borne under a competitively bid scenario.

While building its business, Transurban has created a sustainable competitive advantage for itself by investing heavily in its internal teams. These teams have developed a strong corporate knowledge base within the group. The Westconnex transaction has increased TCL’s exposure to development and traffic risk; we believe that its internal capability to manage projects will hold it in good stead.

TCL’s current 5% yield, we estimate, will have a CAGR of around 5% over the next five years. Given the predictability of TCL’s cash flows this 10% total return looks particularly attractive in the current market.

Cyclical leverage: Link Administration Holdings (LNK:ASX)

Link’s stock price this year has been impacted by the May Federal government budget announcement to move inactive account balances under $6000 to the ATO and secondly the negative sentiment around UK companies facing Brexit.  This uncertainty in the short term presents an opportunity given the medium-term growth outlook for this company remains sound.  Link has a strong track record of success and strong shareholder focus in terms of generating a consistent return on shareholder capital. 

Originally a share registry business with an accounting firm, Link Group has evolved into a provider of technology-enabled administration solutions.  A combination of M&A and organic growth are likely to drive earnings growth 10% pa over the medium term.  Management is well regarded, and the CEO and CFO own circa 1.5% of the stock and strong alignment with STI and LTI strongly aligned to shareholder outcomes. 

Driving the organic growth is inflation-linked pricing, industry fund member growth following the royal commission into banking, increased outsourcing due to increased regulation and complexity, expansion into new markets and increased use of employee share plans.

Link has been acquisitive, buying UK based Capita’s business renamed Link Asset Services (LAS) in 2017 and this month increasing its stake in PEXA to 44%.  PEXA is Australia’s first online property exchange platform to lodge and settle property transactions digitally.  Over 150 financial institutions and 6,500 conveyancers have signed up to the platform with Australia’s largest mortgage bank, CBA also a co-owner of PEXA.  This is a very high growth business.

The integration of the offshore acquisition of LAS has resulted in revenue from international operations growing from under 10% of total revenue in FY17 to around 40%. LAS is a major provider of back-office solutions to the financial services industry in the UK and Europe.   This acquisition is estimated to be around 20% accretive to EPS by FY22E. 

The recent pullback in the share price has increased the value appeal with LNK trading on 15.5x 12-month forward EPS. The prospect of medium-term double-digit earnings growth via this combination of M&A and organic growth is attractive.

Merry Christmas and Happy New Year!

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WaveStone Capital is a boutique Australian equities fund manager with an active, high conviction approach. For further insights please click here




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Principal and Portfolio Manager
Wavestone Capital

Catherine Allfrey is a Principal and Portfolio Manager of WaveStone Capital, which she co-founded in 2006. In this position, Catherine is responsible for investment research, analysis, dealing and investment management across all funds.

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