Build your own wealth shelter

PORTFOLIO POINT: Here’s a strategy to hedge against each of the four risks to your prosperity.

Last week I set out portfolio strategies from a leading adviser to America’s wealthiest people. His advice to clients was to put a slab of their money into safe liquid securities and another slab into a normal equity portfolio aligned to a risk profile of the investment family. But he also suggested a third category: investments to hedge against unexpected events (see Wealth insurance).

He didn’t elaborate but one of his risk hedge suggestions for American investors is to invest in natural resources, which are rarely covered in US equity portfolios. Of course, that would not be appropriate advice for Australians, who normally have high levels of exposure to resource companies in their portfolios.

This week I began by isolating four unexpected events that you might need to hedge against: a serious downturn in China; inflation; the higher cost of money; and oil prices. As I started studying these risks and stocks that would protect you against these events, suddenly across my computer screen came an email from Eureka Report contributor Roger Montgomery.

Roger writes the popular ValueLine column and we both have participated in the Eureka Report series of DVDs. I have a great deal of respect for him and his opinions. This is what his email said:

“I am very worried about the Chinese property bubble '¦ I saw some construction stats and it’s worse than I saw in Indonesia and Malaysia in the 1990s prior to the Asian currency crisis; worse than I saw in Florida in December 2007; and worse than Japan – 30 billion square feet now under construction – that’s 23 square feet for every man, woman and child in China."

I immediately looked back at my first Eureka Report column for 2010, A recession made in China? In this column, I set out some of the European risks that have dominated our headlines for the past six weeks before quoting an alert raised by Par Mellstrom and Carl George of the Pivot Capital Group, the same group that predicted the subprime crisis in the US.

You can read a summary of their analysis either on the Pivot website or via my summary in that same column.

After talking to executives with experience in China, my initial fears have been calmed. For example, BHP believes that while China will have a slowdown but that the current banking curbs are a good move and will prevent disasters from unfolding over the long term.

But the warning from Montgomery and the alert from Pivot Capital suggest a severe setback in China is one of the risks that Australians must prepare for. Unfortunately, it is the one we are least prepared to handle.

Risk 1: Chinese downturn

If there was a serious setback in China then commodity prices, the Australian dollar and Australian shares would go to the floor. Interest rates would rise because our banks need overseas money and the Australian government would have a serious funding problem.

So how do you pick a stock or stocks to cater for that situation? My first inclination is to simply select safe stocks that have most of their assets abroad. Westfield is a good example but it would not escape the global effects of a Chinese downturn. Another traditional defensive group are retailers but a lower Australian dollar would lift the cost of their stock and hurt sales.

The best stock I can come up with is CSL, whose health products are relatively immune to economic fluctuations. CSL derives most of its revenue from US dollars and euros. This was another stock that Roger Montgomery identified as being undervalued back in November (see Healthy, wealthy and overlooked) and has since gained about 10%.

It is true that the stock is priced for growth, which might be stunted in tough times, but it represents a marvellous hedge against a Chinese downturn and the subsequent fall in the Australian dollar. Cochlear and ResMed would have similar attributes. In theory the miners are another good pick but in practice a lower Australian dollar is likely to be linked to a fall in metal prices.

Risk 2: Higher costs of capital

When it comes to the higher cost of money it poses serious questions for the entire market. Two weeks ago I set out the BHP Billiton strategy which is preparing the company for rises in the cost of money on the back of much higher government borrowing, both in the US and Europe (see BHP’s brilliant strategy). There are also new banking capital regulations that will affect the cost of money.

BHP is the first to concede that it could be wrong, and if that happens there is an alternative strategy to buy back the British arm of the dual-listed organisation. But there is no thought of that move or any capital return move when there is a possibility of a significant rise in the cost of capital.

BHP wants to be in top shape to buy depressed assets if they come on to the market so in theory holding BHP would give you a long-term benefit from a rise in the cost of capital. But there will also be a lot of short-term pain because almost certainly commodity prices will fall with higher capital costs.

Your best hedge against a sharp rise in the cost of capital is to buy big Australian bank hybrids. They obviously carry a risk, which makes them vulnerable if an Australian bank were to get into trouble. But that is not likely: the interest rates on bank hybrids will rise with market rates. The table below lists a number of Australian bank hybrids. I would not stray from our top banks when investing in hybrids.

Risk 3: Inflation

The stocks that will protect your portfolio against inflation the best are Transurban and ConnectEast. I wrote about Transurban in November (see Why I like Transurban). The risk with this stock is that right now it is a takeover target and may not be listed here forever if the Canadian pension funds pursue their $5.25 a share bid.

Transurban’s revenue is linked to inflation, and toll roads are a traditional defensive stock that will not be greatly affected by a normal downturn. The Canadians correctly concluded that Transurban was one of the best inflation hedges in the world.

Takeover specialist Tom Elliott has alerted Eureka Report readers that if the Canadians disappear Transurban shares will fall. There is no doubt that is true, but conversely over time they will rise much further as the true value of their assets is recognised. If inflation breaks out they will rise strongly and your portfolio will, too.

In the latest half-year Transurban performed particularly well. ConnectEast operates a toll road on the east of Melbourne, and is, if you like, a poor man’s Transurban. Its revenue is also protected against inflation but its single toll road doesn’t have the same maturity of Transurban’s assets. Nevertheless, the combination of the two investments represents one of the best inflation hedges in the country.

However both companies have borrowings, which are manageable in the short term but if there is a rise in the cost of capital it will reduce their performance but not destroy their prospects. As I wrote last year, my family has investments in both Transurban and ConnectEast for the reasons I have outlined. I can’t get that hedge anywhere else so I am not interested in selling to the Canadians.

Risk 4: Rising oil prices

My final event worth considering protecting against is a rise in the price of oil. Now of course if there is a problem in China or a rise in the cost of capital one would normally expect oil to fall in price. But oil has its own dynamic and it is clear that we are not generating the reserves of oil necessary to match the increasing demand, and traders are beginning to appreciate this growing shortage. So all other things being equal, investors should include the price of oil among the big risks to their wealth.

BHP Billiton has a good oil assets but the uptick in its Petroleum division would be diluted from its other business earnings. For pure oil exposure, Australians would need to invest overseas.

The best the local market can provide is a mixture of oil and gas exposure, and here Woodside and Santos are the two best stocks for you. Woodside’s long association with the North-West Shelf and a number of new projects make it an obvious choice. Santos also has a good variety of projects but its secret weapon is its exposure to emerging and exciting export gas developments on the eastern seaboard.

I would not suggest that the protections that I have suggested against the four risks are an exhaustive risk of investments, but they are a good start. I welcome suggestions from readers because an article like this should be both informative and a thought-starter. If you have any suggestions then please click here.