My desert island picks

PORTFOLIO POINT: Here are the stocks I would choose to set and forget if I were facing a five-year stretch in a desert island hammock.

Due to unforeseen circumstances, I have been banished to a desert island for five years. Before I depart, however, I am planning to make a few adjustments to my portfolio.

Taking into account the dominant macro trends, I expect the next five years to be characterised by:

• An OECD region that continues to struggle; held back by debt reduction, ageing populations and defensive banking systems. The OECD will continue to lose market share to the emerging economies, which now account for about 52% of the global economy.
• Within the emerging economies – particularly China – the transition away from export dependence to a growth model based on domestic demand will accelerate. This will be a natural result of rising per capita wealth but also a deliberate response to the relative weakness in OECD export markets.
• When I return in 2015, I hope it will not be a case of switching from one desert island to another. Australia’s growing reliance on exporting commodities is both an opportunity and a curse. It comes at a growing cost to the competitiveness of the economy; it has lifted the volatility of the cycle and it does not appear to be doing anything to contain our dependence on foreign capital.

For these reasons I fear my investment strategy needs to be extremely selective and in light of these points I have just made, I have arrived at five core investment ideas for my portfolio.

1. Follow the consumer

The global population is about 6.9 billion, of which about 6 billion live in emerging economies. As such, it only takes around 15% of this universe to match the population of the developed world. If, each year, 1% of this universe improves its earnings to the point that some consumption is discretionary, it will deliver about 60 million new consumers into the global economy. This is equivalent to adding a “US economy” of customers to the global marketplace every five years. The “OECD consumer” may be in decline but the “emerging market” consumer has barely arrived.

Accordingly, I want my portfolio to be exposed to the rise of the emerging economy consumer. As a first step, I would like to purchase the iShares S&P Global Consumer Staples (IXI) ETF listed on the ASX. The global multinationals to which this security is exposed will be at the forefront of this structural shift (the top five stocks, which have a weighting of 32% are Procter & Gamble, Nestle SA, Coca-Cola, Wal-Mart and PepsiCo).

When I return, I strongly suspect that Consumer Staples will have been the best performing sector in the global market (narrowly followed by Technology, which will also be a beneficiary of the rise of the emerging market consumer). It already commands a valuation premium, but I can only see this pushing through 40% over coming years.

2. Quality global franchises

For industrial exposure within my Australian equity portfolio, I require a strong bias in favour of the quality global franchises – stocks that have an established presence in overseas markets, a clear strategy and the financial capacity to leverage their competitive advantage. The names that have caught my eye in this regard are:

Macquarie Group: Over 52% of revenue is now sourced offshore and a relatively transparent business structure based on stockbroking, corporate advice, funds management and banking. What chance Macquarie will be one of the top five investment banks in the world by 2015?

Computershare: I am immediately attracted to any global financial services company that was able to get through the largest financial catastrophe since the Depression unscathed (in 2008-09 Computershare’s EBITDA was flat). More than 80% of EBITDA is now sourced offshore. An acquisition strategy where incremental revenue streams are leveraged into an existing IT infrastructure has seen profit margins and returns trend-up up over the past five years. With a growing exposure to the emerging equity markets of Asia I suspect there is more to come.

Ramsay Healthcare: The OECD consumer may be in decline but proportionally, spending on healthcare can only go one way. Ramsay now has about 9300 private hospital beds of which about 2750 sit offshore. Acquisitions in the UK and, more recently, France have established a foothold for industry consolidation. Given the fiscal challenges facing most OECD governments – plus ageing populations – outsourcing healthcare to the private sector will become commonplace.

-Global franchises
	Price	Low	High	P/E
Macquarie	$37.12	$35.20	$58.80	11.46
Computershare	$10.22	$8.48	$12.90	18.1
Ramsay Healthcare	$13.74	$10.20	$15.49	21.37

3. Resources – volume over price

For resource exposure within my Australian equity portfolio, I have far more confidence in the outlook for commodity demand than I do for commodity prices. While one should follow the other, I suspect that at some point in the next five years the logistical restrictions impacting the global supply of coal, iron ore and gas – the three core commodities for the Australian resources sector – will be easing.

If so, the resulting price response could be dramatic, particularly when the next cyclical slowdown opens up excess supply capacity. Thus, given I am locked-in for the next five years; I prefer to play volume rather than price.

Apart from maintaining a healthy exposure to BHP Billiton, the names that caught my eye in this regard are:

Orica: Post the demerger of Dulux (shareholder vote pending), 70% of Orica’s EBIT will be sourced from mining services (explosives), 16% from chemicals and 14% from mine safety business Minova. More than 60% of EBIT will be sourced from overseas with 23% coming from Latin America/Asia. While Orica will have to keep investing to meet long-term demand, I am impressed by its leverage to growth in mining volumes, to a recovery in US construction activity (via quarry volumes) and to the inevitable improvement in mine safety standards in emerging economies.

Tox Free Solutions: Execution risk with a smaller company is always high, but Tox Free Solutions’ national footprint is coming together, its value proposition for the mining/energy sector is established and the strategic advantages provided by unique licenses and/or sites impossible to replicate. With its major domestic competitor (Transpacific Industries) capital constrained and environmental and waste-management benchmarks only likely to get more stringent, Tox Free Solutions will not be short of opportunity over the next five years. As with the other “volume” players I favour, however, it will have to keep investing to access this growth.

Asciano: Thematically, there is no better way to play the Australian economy. Not only do you get exposure to the bright outlook for resource sector volumes via the railway assets in Queensland but, you can also leverage the resulting competitive decay elsewhere in the economy via the ongoing rise in import penetration. The likelihood of new entrants into the stevedoring sector will unfortunately dampen the P&L upside from the latter trend, but an a five year view I should still be left with an outcome that is superior to what the market will deliver.

-Resource exposure
	Price	Low	High	P/E
BHP Billiton	$37.15	$31.33	$44.93	15.98
Orica	$24.94	$18.98	$27.75	14.1
Tox Free Solutions	$2.23	$1.91	$2.80	17.98
Asciano	$1.61	$1.24	$1.94	N/A

4. US housing

I can never resist a depressed cycle and there is no cycle more depressed than US residential construction. Housing starts are currently sitting around 60% below the average for the past 30 years (1.46 million per year). When adjusted for population growth of around 3 million per year, the cyclical hole is even deeper.

On a five year view, I like the odds. It is a fact that the overhang in the US housing market – particularly of new homes – is clearing. From here the downside risk is limited; the issue is simply when the recovery will come through – 2011 or 2012? When it does appear it will be multi-year in duration and deliver significant profit leverage to homebuilders and building material producers who have deflated their cost bases over recent years.

Domestically, James Hardie will clearly benefit from such a recovery (74% of net sales sourced from the US) however I prefer the broader exposure provided by the NYSE listed SPDR S&P Homebuilders exchange traded fund (XHB). The security seeks to replicate the performance of the S&P Homebuilders Select Industry Index, which is an equal-weighted index. I expect to at least double my money over the next five years.

5. A safety buffer

A desert island could yet prove a good place to be over the next five years. To protect myself against the risk of something bad happening – particularly a serious downturn in China, which would flow straight through into Australia – I would like to hold a position in the NYSE listed iShares Barclays 20 year-plus US Treasury Bond Fund (TLT). When the financial world left the rails in 2008, it provided an Australian based investor with a 91% return. During the latest correction it provided a trough to peak return of 25%.

I suspect that the Australian dollar’s high positive correlation with global equity markets – and sentiment towards China – will continue into the medium term. With bond prices generally rising when equity prices decline, I therefore get a double benefit when global markets are hit by a wave of risk-aversion. On the downside, this position will leave me exposed if the US bond market is ever engulfed by sovereign debt fears, but under such a scenario the prospects for the global economy will also deteriorate and with them support for the Australian dollar.

In the hopefully unlikely event that this security again delivers a 90%-plus return inside a six month period '¦ I shall expect someone to sell it for me!

See you in 2015.

Mike Hawkins is the chief investment officer at Evans & Partners.