|Summary: Three fundamental changes are taking place which affect your share portfolios. Money is flying out of Europe amid the Ukraine crisis and a more aggressive Russia – potentially causing a global market correction. The outlook for many of our miners is drastically changing, after mineral prices have declined substantially over the past year. And people are looking hard at their discretionary expenditure with employee incomes not rising, catching a lot of companies in the retail sector out.|
|Key take-out: In reviewing your portfolio allocation you should consider whether you are completely dedicated to income stocks or you have exposure to companies with long-term growth potential as well. Growth stocks are better placed in the current macro environment.|
|Key beneficiaries: General investors. Category: Investment Portfolio Construction.|
Now that the profit season is over, it’s a good time to review your portfolio in the light of the circumstances Australian companies find themselves in.
This review may not require you to make fundamental changes, but we aim to help you better understand the dynamics of the companies that make up most share portfolios.
Three fundamental changes are taking place which will affect your portfolio. Globally we are seeing a flight of money out of Europe, partly because the market senses that the Ukraine crisis is going to change the landscape. Russia is going to be more aggressive and the sanctions will hit Europe. Meanwhile, Russia will increase its economic relationship with China for funding purposes. My view is that crisis will lead to a global market correction. The defensive nature of many Australian portfolios with their emphasis on income will help, but there are two changes locally that your companies will need to be on top of.
In Australia the most fundamental change over the last year has been the substantial decline in most mineral prices, led by iron ore and coal, which has completely changed the outlook of a great many of our miners.
This week we saw some of the best business names in the country – including 'pokies king ' Bruce Mathieson and Fairfax chairman Roger Corbett – get caught in the collapse of Western Desert Resources (WDR). Also caught in the collapse were former major Billabong shareholder Scott Perrin and former Coles Myer chairman Rick Allert, who was also chairman of the ill-fated miner. If you have been caught in the mining downturn ... you are certainly in good company.
The mining businesses for the next year or two will look to grind costs down because it is hard to see an increase in demand for iron ore and coal sufficient to take up spare capacity. In time it will change and the big low cost companies like BHP and Rio Tinto will emerge much stronger.
A second local fundamental change (it is also happening in most developed countries) is that outside government, employee incomes are not rising and people all around the country are looking hard at their discretionary expenditure. And that is catching a lot of companies out – not a dissimilar trend to minerals because companies in that situation have to cut costs to either keep afloat or increase profits.
It is hard to see that changing in the next year or two. We have large numbers of people coming on the labour market from the end of the mining investment boom, the end of motor manufacturing and the sheer impact of the cost-cutting which will be led by retailers.
And of course the decline of iron ore and coal prices means a fall in tax revenues so governments local, state and federal will become tighter.
Cracks are appearing
Not surprisingly we are seeing cracks appear in companies in this environment: revenue struggles are accompanied by vigorous cost cutting. This often causes the companies to be cashed up, enabling cracks to be papered over with higher dividends.
In an environment where people are thirsting for yield given the decline in bank deposit interest rates, any company that lifts dividends is looked at as a hero and adverse signs are cast aside.
Longer term it's important to have a least some companies in your portfolio that are handling the current challenges well and are growing.
In Australia most people have been able to maintain the yield on their portfolios by investing in banks and Telstra. And those investments have been enhanced with higher profits and higher dividends and of course higher share prices which have made the investments very rewarding.
At the moment interest rates on most major global markets are close to zero and, although Australia has reduced rates, they have become high relative to other developed countries. That has caused our Australian dollar to remain high even though our terms of trade are in decline.
The events in Europe and the fall in commodities are starting to push our currency down but if that momentum were to halt it will hurt our economy. Many believe it may even cause our interest rates to fall. If Australian interest rates were to fall then bank shares would continue to rise strongly.
But in terms of basic bank trading, life is getting just that much tougher and the heady growth days look to be over.
We have just seen a continuous fall in bank term deposits because banks have lowered the local rates and moved to cheap overseas borrowing. Next year many of them will have to scramble for local bank deposits, particularly if we get a new European crisis.
All around the banking industry rivals are looking at chipping away at lucrative bank businesses because the high bank profits in Australia are acting like a magnet to groups like Coles, Amazon, Google, etc.
At some point Australian banks are going to have to bite the bullet and invest more in their own businesses. At best some will struggle to hold their dividends, particularly if the squeeze in income and or higher unemployment turns the housing market down. Against current conditions we normally would have seen a moderation in housing prices, but with the avalanche in Asian money plus the tax attractions to local housing, investors have maintained or increased prices.
Pinpointing growth stocks
My bottom line is in the absence of further rate falls the golden days of banks are coming to an end and they are increasingly going to be seen as income stocks. Telstra is in a wonderful position to embark on a growth path but while it is moving around the edges it is being very cautious given its dividend commitments.
In the retail section our two great stars Woolworths and Coles are going to need to work very hard to maintain growth. Woolworths has got itself caught in a hardware mire and Wesfarmers is stuck with coal assets plus is showing signs of a slowdown in momentum because it can’t avoid the effect of stagnant Australian incomes. Retailers like Woolworths and Wesfarmers need strong population growth in these circumstances. But after wonderful periods of growth, in common with the banks, they will find it difficult to maintain past momentum.
Macquarie has listed a number of companies that over the last year have shown to be growth stocks. Their list is by no means exhaustive, but look in your own portfolio to see if you are totally dedicated to income type stocks or if there is growth potential amongst the companies you have supported.
Among the growth stocks that Macquarie isolate are CSL (a magnificent Australian company), Amcor, Domino’s Pizza Enterprises, (that was a real surprise to me) Ramsay Health Care, (I am wary of Ramsay’s French investments) Oil Search, Real Estate.com, Sirtex, Slater and Gordon (complexity of our law is a growth market for aggressive lawyers), Seek (they are seeking to duplicate the Australian operations in China and South America) Magellan Financial, Crown (like Seek they are duplicating their Australian operations off shore) and DuluxGroup.
Remember that Macquarie is a Sydney institution and a great number of the Macquarie growth stocks are located mainly in Melbourne. I don’t want to jump to conclusions but sometimes when you are large, as many Sydney companies are, then hanging on to what you have got is more important than growing the business ends.