Stocks for your stocking
Interest rates and commodities will be the major themes in 2017.
It is turning out to be quite a reasonable 2016, with the sharemarket climbing the wall of worry in the wake of the commodity boom going bust. In February, the All Ordinaries was around 4,850 points and since then, with two steps forward and one step back, the market has risen around 12 per cent.
What does 2017 hold and will the share rally continue? From my perspective there are two major themes: interest rates and commodity prices.
Interest rates are likely to prove a double-edged sword, being a negative for bonds and infrastructure but a positive for financials. In 2016 more than a dozen countries have had 10-year bond rates at or below zero and in my mind this was the penultimate indicator of the end of a 30-year bond market rally.
The irony for investors is that despite government bonds being some of the lowest-risk investments you can own, when you pay too much you can still guarantee you will lose. As they say, don’t fight the Fed (US Federal Reserve), and with interest rates held at close to zero for six years and more than US$700 billion spent on quantitative easing, the US economy has returned to “full employment”.
(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article).
Here are my top five ideas for 2017:
1. Sell or reduce exposure to property trusts and infrastructure
Like government bonds, many of Australia’s largest property trusts and infrastructure funds are very high-quality assets, but if you pay too much you can still lose.
I know the price of many have already fallen 20 per cent, but the likes of Westfield Holdings, Scentre Group and BWP Trust are still trading at at least a 20 per cent premium to their underlying net tangible assets.
2. Commonwealth Bank
Perversely, rising interest rates will actually be a positive for the world’s banking system. Globally, the major banks have hundreds of billions of dollars invested in government treasuries and any uptick in returns is likely to flow through to profitability. When it comes to investment markets, despite the fact that Australia’s major banks avoided the worst of the GFC, their share prices have still suffered.
Global investors have had the opportunity to buy US and European banks at steep discounts to their book value and this has put pressure on the share price of Australia’s major banks.
In my view, CBA has the lowest-risk business model of the big four banks, being biased towards mum-and-dad savings accounts and home loans. Equally, it has out-invested its peers in technology and offers customers a superior digital experience. CBA is winning more than its fair share of new transaction accounts, and with it trading on a 5 per cent fully franked dividend (8 per cent pre-tax) I believe it is well worth a look.
3. Mortgage Choice
Mortgage Choice is one of Australia’s largest mortgage broker networks. The company first listed in 2004 with a loan book of $17 billion and has grown every year, currently sitting at $51 billion.
More than half the loans are with one of the big four banks, 30 per cent is split between the likes of Suncorp, Bank of Queensland, Bendigo Bank and Macquarie Bank; 6 per cent is with building societies; 7 per cent is with credit unions; and the balance with other lenders.
Mortgage Choice has no debt and around $8 million in cash, plus around $89 million net in accrued trail commission owing to it. (Based on the average loan life for the current loan book there should be around $350 million in trail commission to come in but around $220 million will be paid to franchises and $40 million in tax).
Dividends have been maintained or grown every year since the 2008-09 Global Financial Crisis and for the 2016 financial year were $0.165 per share fully franked, which on the current $2.05 share price would be 8 per cent fully franked or 11 per cent pre-tax.
Commodities demand still rising
Commodity prices have been under pressure for at least the past three years. As a consequence, tens of billions of dollars have been stripped from global exploration and development budgets, and inevitably this has led to the curtailment of supply.
Demand on the other hand has continued to rise. This is not a straight line process, but urbanisation and development requires all the basic commodities, as does any attempt to improve and maintain lifestyle and living standards. Over the past three years the Indian, Chinese and Indonesian economies (which collectively account for around a third of the world’s population and 20 per cent of the world’s economy) have continued to grow at above 5 per cent.
I note that given the heavy capital nature of most commodity businesses, the boom-bust cycle will typically take years, if not decades, to play out. So these next ideas are not based on any short-term view around commodity prices, but rather a view that the only way to invest is to buy large, low-cost, long-life assets during “the gloom”.
4. BHP Billiton (and Rio Tinto and Woodside)
I know BHP’s share price is up 60 per cent from this year’s lows, but it owns some of the world’s best iron ore, copper, coal and petroleum assets. The company’s $20 billion debt is “modest” given its $80 billion in property, plant and equipment, and $10 billion in free cash flow.
There is no way of knowing where commodity prices will be next year or any year, but you can be certain that the only way to build and sustain a modern economy is with steel, copper and energy, and BHP is one of the world’s most efficient suppliers of these commodities.
5. Murray Goulburn’s MG Unit Trust (MGC)
The secret to making money is to buy low and sell high, but perversely this will mean buying things out of favour and selling things in favour, and MGC has certainly had its fair share of negative press in the past six months.
MGC is Australia’s largest dairy processer, accounting for more than a third of production and more than half of all dairy exports. MGC is 100 per cent controlled by its dairy farmer suppliers, but the economic interest is shared, so one non-voting MGC unit will have the same economic interest as one dairy farmer supplier voting share.
The current MGC structure was set up in 2016 to raise $400 million to help Murray Goulburn fund the ongoing investment and expansion into state-of-the-art processing facilities. The key to the success of any investment in MGC will be the global milk price, but just like mining, low prices will lead to lower spending, on things like irrigation, fertilizer and supplementary feed, and this will reduce the milk supply.
Equally, as developing nations such as China, India and Indonesia continue to strive for higher standards of living, there will be an increasing demand for dairy products. MGC suits patient investors looking for exposure to one of Australia’s strongest agricultural industries.
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