Intelligent Investor Equity Income & ASX:INIF - October 2018
October lived up to its haunted past for investors, as markets spent the month spooked by volatility and economic concerns. The falls were widespread, with the Equity Income Portfolio falling 7.3% compared to the 6.1% fall in the All Ordinaries Accumulation Index.
The list of worries seems chilling. But despite many stocks falling over 30% from their highs, the US economy is growing quickly and it’s unlikely to hit a brick wall for at least a year or two as interest rates increase. Unemployment is low and falling in the US and Australia, though the real numbers of those looking for work is much higher than the official statistics suggest.
Interest rates remain low, and despite some markets being overvalued (including numerous property markets around the world), the falls in October essentially brought the Australian stock market back to its long-term average valuation.
Unlike the US market, which is currently priced to offer a lousy 3-5% annualised return over the next decade, the Australian market’s comparatively poor performance since the GFC means it should return around 8%, largely in line with its historical average.
The path of returns from year to year promises to be rocky, as we combat our world-beating swag of mortgage debt. But combined with franking credits (for now), the potential returns from the stock market look far more attractive than those for other popular investments, such as property and anything linked to pygmy interest rates (see How will you deal with zero interest rates?).
The returns will be even better if we continue our long historical record of outperformance. As our portfolio is quite different to the index, the performance will also vary from year to year. But unlike a good holiday, successful investing is all about the destination, not the journey.
Despite October’s volatility, most high-growth stocks that we’d like to own offer no margin of safety, so our biggest advantages for now are patience and acting quickly when there’s an opportunity.
This is not the time to be overreaching. There are numerous areas where we expect investors will get their hands chopped off ‘reaching for yield’ e.g. using debt to juice returns and buying income securities where you’re taking equity-like risk for fixed income returns. As US interest rates rise, our conservatism gets closer to being rewarded.
Shortening franking credits
A popular question we’re being asked is what happens if Bill Shorten ends franking credit rebates for low or zero-taxed individuals.
First, there wouldn’t likely be any change to your distributions from InvestSMART. The only difference is that you wouldn’t be entitled to a franking refund, which you’d show in your tax return.
Second, many expect it would have a big impact on share prices, as more Australian investors consider investing abroad, for example, or start favouring A-REITs and infrastructure stocks where after-tax dividend yields are higher than those offered by stocks they currently own.
We wouldn’t expect much change because franking credits are only one part of the investment equation and superior investment alternatives to owning a portfolio of high-quality businesses paying increasing dividends as their earnings grow are virtually non-existent.
Investments related to interest rates currently offer dismal returns, and few investors want to invest their money abroad in unfamiliar markets and companies. As long as the Australian stock market is offering a 4-5% dividend yield before franking, your dividend yield is nearly double the 2.8% you’ve historically received in the US, for example.
Any changes in company values would likely be marginal, but it would be interesting to see if any companies reduce their dividends and reinvest more to grow their businesses.
Few, if any, companies would be willing to dramatically change their dividend payout policy with a rusted-on investor base expecting large dividends, but this could produce higher company values for businesses that can invest more at high rate of return. The question then, though, is why they wouldn’t be doing that already.
We’ll spend more time in the quarterly report explaining the investment case for October’s new additions, but for now they include fibre cement company James Hardie Industries, AMP and Platinum Asset Management.
Anything related to the slowing US homebuilding market has been dented or smashed. US homebuilding stocks have been sawn in half or more, and James Hardie is down over 20%.
Longer term the US housing market will need to provide enough homes for the millennial population, America’s largest population cohort, as they have kids and buy homes. James Hardie is well placed to benefit (as is US homebuilder NVR for anyone interested in high quality US stock ideas).
We swapped AMP for IOOF as they face similar risk, but AMP will prove much cheaper if incoming CEO Francesco De Ferrari can get anywhere near the 15% return on equity needed to bank all his incentives.
He also has six million reasons to double the current share price to $5.25 and will likely start with plenty of money to invest or return to shareholders. A new CEO is often the catalyst for restoring the value of a business, as I’ll discuss in a webinar on 21 November where you can submit questions.
We swapped Perpetual for Platinum Asset Management, as Platinum’s share price has fallen around 40% like Perpetual’s, but Platinum’s funds have historically distinguished themselves in tough markets. Platinum’s funds have suffered recently from their Chinese exposure, but the Chinese market looks cheap and is providing opportunities for future outperformance.
We sold Ansell and ASX due to their high valuations and IVF treatment companies Monash and Virtus, as we don’t believe their statistical cheapness is enough compensation for their weakening competitive advantages.