The stock bombs of 2014 - Pt 2
Yesterday, it was the turn of Nathan Bell, Gareth Brown, Greg Hoffman and Richard Livingston. Today, our resources analyst gets us underway.
Gaurav Sodhi, resources analyst
Shale gas has been hailed as a revolution but actual production has generated little free cash flow for producers. This year may be the one when questions are asked about the sustainability of production.
Most producers make money by selling real estate to one another rather than from production, a situation that is unlikely to last. Companies like Aurora Oil & Gas (see review from 11 Dec 12 (Avoid – $3.38)) and US-listed Chesapeake Energy should be worried.
Key Points
- Questions will be asked of US shale gas producers
- Strong reiteration of risk posed by banks and danger of PER creep
- Specialty fashion retailers will struggle
I’d also agree with the opinions already expressed on the banks. They’ve been wonderful performers for decades but today we are faced with a set of unfavourable circumstances: credit growth is low and expected to stay that way; provisions have been pared back to the bone; costs have already been stripped out and the big four banks are all expensive. They may not be disasters but it's hard to see how banks will replicate the performance of the past few years.
James Carlisle, senior analyst
My two biggest concerns are Europe (the euro will have to go eventually) and China, which would be a world first if its leaders can engineer a ‘soft landing’ after decades of tearaway growth.
It’s hard to know how likely these things are, and in any case it’s often the problems no-one has thought of that do most damage. But that’s not really the point: what matters is making sure your wealth can withstand these potential shocks.
One of the other lessons from the GFC was that when trouble comes, the good gets sold with the bad. So, given that my alternative is a risk-free 9% a year pre-tax by paying off some of my mortgage (almost a no-brainer at the best of times), I’m trying to force myself to reduce my shareholdings and pay down debt.
That said, even after a serious recession we’ll all be spending the same portion of our weekly wages at Woolworths. So it’s not so much about the bombs themselves as the quality of your bunker.
On that score, I think there’s been some ‘PER creep’ recently, similar to that experienced in 2007. Too many investors are stretching to justify ever higher earnings multiples because they want to remain invested in (or buy into) stocks that seem to keep going up.
The trend might seem like a friend but watch for the bend at the end! Highly rated stocks can fall quickly on the slightest of bad news. We saw this recently with REA Group, which dropped 15% over two days, from a prospective PER of 40 to 34, when chief executive Greg Ellis announced his departure.
The fall had more to do with high expectations than his departure, showing how even the best stocks have little room for error. Domino’s Pizza on a PER of 40 and Ramsay Health Care on 35 are other examples that come to mind.
Like Greg, I’m also worried about companies with businesses being made obsolete by the internet. We’re already a long way down that path with newspapers, and I’d bet the free-to-air TV companies won’t escape.
Graham Witcomb, junior analyst
First on my list of stocks not to own would be the banks. I’m not sure I’d be overly comfortable owning them even in the best of times given their innate complexity and leverage. And a reliance on foreign funding makes the whole thing look like selling tornado insurance in Oklahoma.
But I would be least comfortable owning ANZ Bank (last reviewed on 29 Oct 13 (Sell – $33.63)) as its overseas expansion plan just adds one more gear to fail, not to mention its relatively low returns on capital.
The other bomb of note tends to be its own catalyst – overvaluation. Stocks have had a terrific run since the GFC and there are now several that have well and truly passed our Sell recommendations. Companies like Australand, Domino’s Pizza, James Hardie and Ramsay Health Care won’t trade above their intrinsic and replacement value indefinitely, capitalism will see to that. If you pay too much, even the best business can turn out to be a lousy investment.
Jason Prowd, analyst
Like Graham, I'd say the most likely 'bomb' to go off in 2014 is the race to quality. As interest rates have fallen, almost every industrial company has been bid up. Many investors are expecting earnings growth, which for a whole host of reasons – a slowing resources boom, rising unemployment, thriftier consumers – is unlikely this year.
If you pay 25 times earnings for a company you’re assuming that either earnings are going to grow rapidly or interest rates are going to remain permanently low. Neither is especially likely.
There's a host of companies including Ansell, Austbrokers, Dominos, IRESS, Invocare, Village Roadshow and Slater & Gordon that are all decent enough businesses but trade on 20-plus forward PERs. Fifteen times is probably fairer.
I’m not rushing to sell the quality stocks from my portfolio but I do think investors should acknowledge that most of our returns from owning high quality businesses over the past two years have come from revaluation rather than earnings growth. That means that share prices could just as easily fall while the companies themselves continues to tick along nicely.
As to other risks, I wouldn't be surprised if we see more shocking results from the listed retailers this year. Consumers have continued to squirrel away cash and the competitive environment just keeps getting tougher, especially for apparel retailers. My bet would be poor results from Premier Investments' Just Group or Specialty Fashion Group.
Prepare now
After asking the team, a few general themes emerge. First, if you haven’t yet diversified away from Australian equities, take advantage of the still historically high Australian dollar by investing overseas.
If you’re happy to do your own research check out Overseas stock opportunities part 1and part 2. If you not, we’re sure Steve Johnson and his team at Intelligent Investor Funds would happily do so on your behalf. Or you could try other fund managers specialising in international markets like Platinum Investment Management or Magellan Financial Group. Either way, reducing your exposure to the Australian economy is a very sound strategy.
Second – and we’re sure you’ve heard this one before – if you must own the banks (and please note that our model portfolios have done very well without a large bank position) please limit them to no more than 20% of your overall portfolio.
Third, the recent share price rises in high quality businesses have been driven by low interest rates rather than earnings growth. These high PER stocks are susceptible to price falls when that truth is realised. You don’t need to sell out completely but locking in some gains to build your cash holdings or pay down your mortgage may make sense for some members.
Fourth, there are still plenty of sectors, including old media, mining and engineering services, specialty retail and the floats towards the end of last year that should be avoided altogether.
Each year brings its particular opportunities and this year will be no different. In getting your overall asset allocation right, and avoiding those stocks that look temptingly cheap (or expensive), you’ll be in a very strong position to take advantage of them.