Ten things you must do in 2016

Your investing guide for the year ahead.

Summary: 2016 is the year to reevaluate the cost of dividends – as the banks and miners face margin pressure, investors should be looking for yields from sustainable sources. Keep in mind that cash may get better as US interest rates rise. Consider the rise of social impact investing that aims to do good rather than “avoiding bad” investments.

Key take out: Know the strengths and weaknesses of popular asset types: take time to understand small cap stocks in 2016 but be aware of the changing tempo of this space, and view ETFs as a useful but far from perfect investment type.

Key beneficiaries: General investors. Category: Shares.

Every year I try to make a reasonable assumption on the key strategic calls that any Eureka Report subscriber will need to make in the coming year.  This year – as in previous years – the ‘ten things you must do’ is as much a personal memo as an editorial feature and you’ll notice personal details dotted throughout the ten segments below.

How did we do last year? Pretty well.

Here’s last year’s ten points – you can read the full feature here.

1 Ride the dollar all the way down

2 Borrowing: Do it sooner rather than later

3 Avoid general index funds and ETFs in Australia

4 Position your portfolio with regard to oil

5 Stick with residential property

6 Investigate peer-to-peer lending

7 Agricultural stocks: Check your bias

8 Don’t put all your eggs in the DIY basket

9 Look at LICs

10 Extend your hunt for yield

In the year ahead some of the dominant issues of 2015 will remain, but they are no longer so urgent: the Australian dollar may fall further, but nothing like last year, rates may remain low but not for so long, the hunt for yield remains but the need for yield is no doubt fully understood by all our subscribers by now.

So, we look towards 2015…here’s my top ten:

1. Reassess the cost of dividends

For the last five years, retail investors have rushed towards high yielding stocks as cash rates fell. The major banks responded by enthusiastically lifting their dividend payout ratios to unprecedented levels and rival blue chips jumped into the game, concentrating on progressive dividend policies - BHP, Orica and the major insurers typify the trend. Now the big dividend payers are facing pressure and dividend policies are under fire.  For the retail investor the question is: does the high franked dividend come at a reasonable price? Certainly when banks were offering strong dividend and good underlying capital growth, the deal was attractive – this year banks did not manage that while the new arrivals to the dividend game, such as BHP, came under intense fire.

In 2016 income from the share market will be absolutely dominated by the “quality” of dividends. As we break for new year, here are some high - but unconvincing - dividends yields: BHP 10 per cent, Woodside 10 per cent, Myer 11 per cent, Seven West at 13 per cent. All of these companies are facing serious challenges and in reality the investor may never get this yield - or alternatively they will get a “good” dividend but incur capital losses as the share price reflects the challenge to the company facing low oil prices, or poor tv advertising income, or soft retail sales. Among the stocks we trust to deliver a good income at reasonable prices in the year ahead are ANZ and NAB along with mid-caps Tatts and DWS.

2. Step up the search for non-correlated assets

The search for assets that will not “crash” if the stock market declines sharply is all the more important in 2016. Wall Street – the locomotive of global stock markets – is more vulnerable to a sharp downturn as it continues to extend a very long broadly successful run since 2009, one which is increasingly dependent on a handful of tech and industrial leaders such as Apple, Alphabet (Google), Microsoft, Facebook, GE, Johnson and Jonhson and Exxon Mobil.

What we have learnt from previous sudden downturns on Wall Street is that ALL Australian listed markets fall in tandem…often falling harder than Wall Street itself. Crucially, we also know from the GFC that anything listed  on the markets falls regardless of it’s categorisation: In other words LICs, ETFs, hybrids . ‘defensive stocks’ will all fall in a panic.  That’s why you need non-correlated assets which must not be listed on the market: Unlisted trusts, unlisted funds, private equity funds, hedge funds, property and cash all fall into this category. It is also worth considering that investing in start up ventures will have strong tax inducements from July 1 2016 including a ten year total exemption from capital gains tax once the investment is held for three years.

3. Consider that cash may get better

As I’ve said earlier, the hunt for yield remains a major theme. But in 2016 the issue of cash allocation becomes crucial for two reasons:

1. Global interest rates are at last beginning to rise

2. Locally some sources of yield - such as bank stocks - clearly got overpriced in recent times.

The move by the US Fed to lift interest rates for the first time since 2006, coupled with prospects of further rate hikes during 2016 as signalled by Fed chair Janet Yellen, means cash will become a better investment in 2016. In Australia the rates outlook is mixed. We can find forecasts predicting both rate cuts and rate rises. 

The key point here is that cash has been a losing option for several years and there are now clear signs this is coming to an end.  With serious fears in the bond market – and some dramas already unfolding in the junk bond sector – the prospect that cash could pay better by the far end of 2016 is a very reassuring prospect.

4. Be super vigilant on small caps

Speaking as someone who took Eureka’s advice in early 2014 to “get into small caps” very seriously, I can say I am very happy indeed with how this strategic move has worked out. I did not have all the small caps in the Eureka Report model portfolios – you can check the portfolios of myself, Alan Kohler and Bruce Brammall at any time by clicking here – nonetheless it has provided the core of capital growth to my wider investment portfolio during the year.

Here are the details: I held three big winners in the small cap space: AMA (Eureka Report recommended), Vita Group (ER recommended) and Hansen. I also had two loss makers, Azure (ER recommended) which I sold (ER recommended selling on December 7), and Capitol Group, which I still hold (it remains a hold as advised by Eureka Report Growth First model portfolio).  I also had Qube Holdings (QUB), which is playing a very big takeover game around Asciano and ended more or less flat for the year, and Icars Asia, which I picked up mid-year and has managed some solid gains. Separately, I had an ASX-listed ETF which concentrated on US listed small caps – IShares Core S&P small cap ETF (IJR), which did reasonably well over the year – and has more than doubled since I picked it up four years ago.

But the one thing I have learnt from this new concentration on small caps is that you absolutely must be “across” these stocks and the tempo can change quite quickly. More to the point I must bravely follow Doug Turek’s advice in the months ahead and sell some of my winners and back new winners for 2016 (see Holiday edition: Finding perfect balance in 2016 here). To do this I will draw from the recommendations of our Eureka Report analysts in the first quarter of the new year.

5. You might give fund managers a second chance

In the wake of the GFC, the retail investment market turned against fund managers as their inability to save investors from the losses that swept through the market at that time became awfully clear. Worse still, the level of fees charged by many managers continued at a high level even when returns were poor. Now as we enter 2016, it is clear that many fund managers have both improved their professional standards and are considerably more transparent on fees.

What’s more as we face a low growth market, the ability of a fund manager to return strong returns after fees is very well appreciated. Indeed as Alan Kohler often maintains, “it’s not the fees it’s the performance”, in other words he’s willing to pay handsomely for handsome performance figures.

Certainly in specialist areas such as offshore investing and small caps stock picking, it is clear that fund managers can add value. Kirstie Spicer’s feature today on top managers, which includes names such as OC Dynamic, Smallco, Hyperion, Lazard, Macquarie and Magellan, is worth examining – read it here: Holiday edition: our favourite managed funds.

6. Examine China consumer stocks

The spectacular success in 2015 of the “infant formula to China” stocks such as Bellamy’s (up 670 per cent) and Blackmores (up 481 per cent) may well be more than just a niche sector doing exceptionally well in a narrow period of time. The wider theory that China is moving from its “iron and steel” phase of industrial revolution to a full-blown consumerism has been gaining credence in recent times and the infant formula boom could be the start not the end of something much bigger.

Whether China makes a GDP of 7 per cent or 6 per cent hardly matters to stocks that are well-placed to serve China’s consumer market.  There are several ways into this story. There are funds and ETFs, but the biggest – and riskiest – opportunities will be ASX-listed stocks with this focus. At Eureka we have recently recommended (December 14) Pental (PTL), which is developing a sales plan for launching soap and powder products into the China market.

7. Explore impact investing

In the same way that peer-to-peer lending emerged as the “new thing” of 2014 and has since moved into the mainstream, perhaps the outstanding new theme of 2015 was the emergence of impact investing – investing which is actively engineered to “do good”, as opposed to traditional ethical investing which concentrated on avoiding controversial investments such as arms, tobacco and gambling.

Emerging in the US, and initially driven in Australia by then NSW Treasurer Michael Baird, the most visible aspect of this style of investing is social impact bonds. Among the best known bonds in this area are the Newpin Social Benefit Bond - a collaboration between the NSW government, the Uniting Church and Social Ventures Australia, which aims to return children in out of care homes to their families, and The Benevolent Society Bond, which seeks to promote “resilient families”. The Newpin bond has delivered an 8.9 per cent per annum return in the first two years of its seven year term.  More broadly, impact investing is emerging in private housing developments, such as the Commons projects, led by the Breathe architecture group in Melbourne and similar ventures in other states. If the US is anything to go by we are just at the start of impact investing, but investors will need to see these initiatives primarily as instruments for social change until the sector matures further in Australia.

8. Understand that property trusts are showing signals of overheating

Put it this way – A-REITs delivered seven times better than the wider market in 2015:  this is a total accumulated return of 14 per cent against 2.1 per cent for the ASX 200 accumulation index. They did not get sold off in common with the banks because they did not get a “perfect storm” of regulation hitting them over the last 12 months.

But property trusts have a notorious reputation for running too fast when the money pours in. History suggests they overpay for assets, squeeze profits from fees and steadily lose touch with reality until a sell-off brings them back to land. 

There is evidence in a new Macquarie Bank report which suggests lower affordability, wage inflation and cooling investor demand will impact Mirvac, Stockland and Lendlease.  Moreover, the wider AReit market, where commercial property underpins portfolios – think, Charter Hall, Dexus, GTP etc. – are all exposed to a very buoyant commercial property market which is not as yet matched by a buoyant local economy. If you have been depending on this area for yields, the risk is that AReit yields – in common with bank stock yields – will be sustained, but underlying capital losses could be a threat in the new year.

9. Understand that the US remains the best offshore market

The prospect of “rising the dollar all the way down”, which we all enjoyed last year, does not present itself to the Australian dollar investor in 2016. Nevertheless the US market remains the most attractive offshore market in the year head for retail investors.  Though there is the prospect of a dramatic rebound in Europe there is also the prospect of more trouble through an exit of Britain from the union among other issues. 

As our colleagues at Barron’s have opined in today’s special edition, the “collected wisdom” of the best minds on Wall Street determine that the S&P 500 should do 10 per cent or so in the year ahead…within that broad target there should be very good opportunities for Australian investors in both selected stocks and specialist funds. The Barron’s team again favours technology and financials on Wall Street in the year ahead. Among stocks recently recommended by Eureka Report in this category would be Amazon, Alphabet (Google), Facebook, New Relic, MobilEye and Splunk. (You can read more about Eureka’s international stock coverage here: Eureka international stocks: new plans, December 2 2015.)

10. Know the failings of ETFs

There is, unfortunately, no such thing as the perfect investment – or for that matter the perfect investment vehicle. At Eureka Report we have covered Exchange Traded Funds since they first hit the market in a meaningful way about a decade ago. The advantages of these index-like listed funds are obvious. They allow you to enter a basket of investments through a low fee structure (I’ve invested in the ASX-listed ETF called IJR detailed in section four in this piece).

But the explosion in ETF issuance in the US and the growing usage of the funds in Australia now that financial advisers are more willing to recommend them brings about some issues we did not perceive ten years ago.  John Abernethy pointed out in these pages (see ETFs vs LICs, April 8 2015) during the year the ETFs must sell into falling markets, in that respect they are a weaker structure than LICs (they are open-ended against LICs which are closed-end).  Elizabeth Redman also pointed out that not all ETFs act in the same manner though an inexperienced investor might reasonably think they do (see How to choose an ETF, July 8 2015).

What’s more, ETFs can face real problems if markets are very volatile, and there have been hints of this during particularly active periods for gold in the past as well as earlier this year in the US market, when there was liquidity problems for US ETFs during some very volatile days.  The biggest fear is that we have not seen how ETFs fare in a market crash on the ASX  – my sense is that when there is one (not if there is one), ETFs will makes things worse for those in them and the wider market.  So the message here is that ETFs are useful but are far from perfect. Like every other investment the secret is to be careful, be selective and diversify your investment activities.

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