Still time to get on board for value stocks

Still time to get on board for value stocks

September 2020 marked what could be one of the most significant changes in the stock market for the past 12 years: value stocks started to outperform growth stocks. Importantly, this rotation could go on for a long time to come, offering opportunities for substantial gains.

What is meant by ‘growth’ and ‘value’ stocks?

Growth companies are those whose earnings can grow independently of the broader economy, the classic example being tech companies, or some health care stocks. Value companies are those whose earnings go up and down with the economic cycle, thus they are also called ‘cyclical’ stocks.

Since the GFC ended, value stocks have underperformed growth by the greatest margin ever. Why did that happen?

Cyclical stocks are dependent on what you might call ‘organic’ GDP growth. On one side of the economy, the GFC caused a massive slowdown in private sector growth as companies tried to get their balance sheets back in order by reducing borrowing, and on the other side, governments all over the world tried to reduce their spending to avoid blowing out national debt levels, a policy also known as austerity.

The consequence was the post-GFC economic recovery was the slowest and weakest on record, so it followed that cyclical companies’ earnings growth was also weak. Naturally, investors backed growth companies instead.

Why are value stocks back in favour?

Governments around the world have responded to the COVID crisis with massive amounts of fiscal support, which has ignited organic economic growth. Here in Australia the federal government has injected the equivalent of 13 per cent of GDP in brand new money, plus another 2 per cent came from early superannuation withdrawals. In the US it’s been a mind boggling 25 per cent, and even Europe has joined in.

The upshot is, after most economies reported record falls in GDP in June of last year, we’ve seen a sharp reversal. Australia recorded back to back quarterly GDP growth above 3 per cent for the first time in the 60 year history of the National Accounts. And in the US, Goldman Sachs is forecasting 2021 will see 8 per cent growth for the first time in 70 years.

As usual, the share market has anticipated the reversal of economic fortunes and value stocks have already enjoyed a sizeable rally. From its bottom last year, the Australian bank sector has bounced 39 per cent, energy by 34 per cent (after oil famously traded below zero last year) and materials 17 per cent.

Why value stocks could rally for a while yet

While they are sizeable moves already, it’s possible the rotation toward value stocks will continue for some time yet. The sheer size of the government stimulus packages saw the Australian household savings rate peak at 20 per cent, and it’s still at 12 per cent, which represents a lot of potential spending still to come. In the US, households are estimated to be sitting on more than US$1.6 trillion in savings, or about 9 per cent of GDP.

Another reason is shown in the chart. In the 12 years since the GFC global value stocks gave up almost 30 years of outperformance against growth stocks and appear to have only just started to claw some of that back. There have been other attempts to turn the tide that were short lived, but none have been backed by such a compelling change in macro support. Indeed, Richard Bernstein of Bernstein Advisors, formerly the Chief Investment Strategist at Merrill Lynch and one of only 57 inductees to Institutional Investor magazine’s Hall of Fame, said “the difference in performance (between value and growth stocks) could be startling to investors over the next couple of years”.

Still time to get on board for value stocks graph

How to position your portfolio

There are plenty of value-oriented fund managers you can invest with, like Perpetual and Platinum. I’ve also written previously that I think the resources sector faces a strong outlook. There are unlisted managed funds that specialise in that area, like Ausbil’s Global Resources Fund, or a listed one is the Tribeca Global Natural Resources LIC (TGF.ASX). BetaShares has an Australian resources ETF, but 53 per cent is invested in BHP, RIO and Fortescue, so it’s heavily influenced by the iron ore price.

For global exposure, VanEck’s new VLUE ETF uses a proprietary ‘Value Enhanced’ algorithm to invest in a basket of 250 value stocks from across the developed markets ex-Australia. And finally, Europe, the UK and Japan also offer a value-oriented bias.

Call us today if you’d like to discuss how to gain exposure to value stocks in your portfolio.

How to pay off your mortgage sooner and accelerate building your wealth

How to pay off your mortgage sooner and accelerate building your wealth

For most people, their mortgage will be the largest debt they will have in their lifetime. Because there are no tax benefits on this type of debt, it’s worth considering paying it off (or at least partially down) quickly so can make the most of the opportunity to accumulate wealth outside the home.

So, here are a few tips which can help you get that mortgage down.

1. Get the right loan from the start

There are so many factors to consider when deciding which is the most appropriate loan. And the loan your friend has may not be the best loan for you. Just like the loan with the lowest advertised interest rate could cost you more in the long term.

2. Understand how to use your loan

Once you have gone to the effort of structuring your loan correctly, it’s important that you know how to get the most benefit out of it. For example, an ‘offset’ account may not help you pay your home loan quicker unless you have the discipline to use it as it should be used.

3. Increase your repayments – every dollar helps!

Whether it be a lump sum payment or increasing your monthly repayments, every extra dollar will result in a saving to your interest cost and thus will reduce the time to repay your mortgage. At a 2.5%pa interest rate, an additional $200 per month repayment on the average mortgage will save approx. $30,000 in interest costs. At a 4.5% interest rate, this increases to approximately $60,000 in interest costs

4. Work on your loan early

During the early years, a higher proportion of your loan repayments are going towards paying the interest expense, with a smaller portion reducing your principal owed. So, commiting to make larger additional/lump sum repayments during the initial years of your loan will repay a larger amount of the principal and so will save on the interest costs.

5. Ask your bank for a discount

You’ll be surprised with the reduction you may get on your interest rate if you just ask.

6. Better still use a pro-active mortgage broker

A great mortgage broker is invaluable. From recommending the best loan specifically for you, to explaining how to best utilize it to getting on the front foot and asking the financial institution for a discount. Our lending manager, Cameron Purdy was able to secure our client a further discount 18 months into her loan by simply getting on the front foot and negotiating with bank. It resulted in a saving of over $900 per month!

7. Build Wealth while accelerating your mortgage repayments

A ‘debt recycling’ strategy enables you to simultaneously pay off your home loan sooner, while building an investment portfolio.

So rather than wait until you pay off your loan before commencing the build up of your wealth/investments, you can start doing it now!

And while the investment portfolio is growing, the income it generates is directed towards the home loan acting as another source of repayments and accelerating the time taken to be mortgage free!

Debt recycling is an extremely effective strategy and while popular among many professionals, it is something all who have a mortgage should consider.

Resources stocks will benefit from a commodities supercycle

Resources stocks will benefit from a commodities supercycle

Analysts and fund managers have recently been lining up to explain why commodity markets are on the cusp of a potentially multi-year bull market. Rockstar analysts Jeff Currie, global head of commodities at Goldman Sachs, and Marko Kolanovic, macro strategist at JPMorgan, go so far as to describe it as the beginning of a ‘supercycle’.

In the last two commodities bull markets, which happened either side of the GFC, major global resources companies rose four to five-fold, far outstripping the broader share markets, though it should be remembered the fall in between was precipitous.

Analysts describe the conditions as being in place on both the demand and supply side across almost the whole commodities complex.

Multiple drivers of demand

In the near term, the almost explosive post-COVID recovery some economies are seeing, fuelled by massive government spending and access to cheap credit, has already seen commodity prices respond. Copper has doubled since its lows of March last year, and now trades at nine-year highs, iron ore has more than doubled and is at 10-year highs and, after falling spectacularly to below zero in 2020, oil is back above US$60 per barrel. The Bloomberg Commodities Index has risen 44% from its lows of 2020.

As well as expectations of an ongoing rise in commodities-intensive infrastructure spending and construction activity, Currie points out the inexorable shift toward green energy underpins huge increases in demand for energy related metals. Already, lithium, a foundation element of most modern batteries, has risen 45% since the start of this year, and cobalt is up 58%.

The European Commission has estimated its Green Deal will require more than €1 trillion (A$1.5 trillion) to be spent over the next decade, and both China and the new US administration have endorsed a move to being carbon neutral by mid-century. With the three largest economic blocs in the world moving in the same direction, the implications for commodities demand are enormous.

Supply will struggle

COVID has also impacted the supply side of the equation, with production out of South America, which accounts for one third of global copper and iron ore production, suffering significant falls. James Stewart, co-lead portfolio manager of the Ausbil Global Resources Fund, argues in addition there has been the typical underinvestment in bringing on new mine production that you see in the aftermath of a commodities boom.

“In 2012 total mining capex was about US$75 billion, and then it fell like a stone to hit US$20 billion in 2016. While it’s picked up since, in many areas the mining industry is nowhere near where it needs to be just to replace annual consumption, let alone expand production,” he said.

For example, copper requires around 300,000 tonnes of new production per year for supply to remain constant, which translates to around $10 billion of capex, and there are no new large mines slated to come into production for at least the next year.

Currie describes most commodities as facing structural deficits, and Stewart agrees, “The process of getting even a small mine up and running, from finding the resource, to defining reserves and then building the infrastructure, can easily take four or five years, and for a big mine it can be 10.”

Stewart’s fund has been investing heavily in mining companies that supply the battery industry, where Bloomberg forecasts demand for nickel and aluminium will rise 13-fold to 2030 and lithium carbonate by nine times.

Longview Economics argues commodities, relative to equities, are as cheap as they have been in more than 50 years, lower than before the start of previous supercycles in 1969, 1987 and 1998.

A hedge against inflation

A further argument in favour of investing in resources stocks is as a hedge against the frequently cited possibility of a rise in inflation, driven again by the sharp rise in post-COVID demand. Commodity prices tend to rise with inflation, driving earnings for mining companies, which could offset concerns about the effects of rising bond yields on a portfolio’s growth stocks.

It’s not often there is such strong consensus among analysts and fund managers. Obviously a smart investor should always consider the counterfactual, but the fundamentals of demand and supply are stacking up to suggest resources stocks could be entering a multi-year uptrend.

Billionaire’s ‘epic bubble’ call may be wrong

Billionaire’s ‘epic bubble’ call may be wrong

Jeremy Grantham is the legendary former Chief Strategist of fund manager GMO. In his 82 years there’s very little he hasn’t seen in financial markets, and he rightly earned his legend status by calling the last three great stock market bubbles: the Japanese equities bubble of the late 1980s,  the US dotcom bubble at the end of the 1990s and the 2008 GFC.

So it’s understandable people took notice when he greeted the new year with a frightening declaration:

The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behaviour, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.

Consider the counter factual

It sounds absurdly presumptuous to take the other side against such a storied investor, but I believe Grantham’s arguments warrant some context, and smart investors should always consider the counter factual.

First, Grantham has warned of an imminent US stock market collapse literally every year since the GFC and always for the same reasons: over extended valuations and the market’s reliance on central bank support. Grantham made a career out of identifying stock market bubbles, but even he conceded in an interview with Barron’s in 2015 that “for bubble historians…it is tempting to see them too often.”

Second, Grantham points to the S&P 500’s PE being in the top few per cent of its historical range while the economy is in the worst few.

With respect to the PE ratio, there have been spectacular changes in the macro, or big picture, settings for stock markets that have dramatically affected valuations. For example, inflation and interest rates have undergone the greatest ever reversal over the past 40 years. After interest rates peaked at close to 20 per cent under Fed President Volcker in the early 1980s, they have drifted lower and lower ever since, to the point where now we are becoming accustomed to negative government bond yields. Likewise, inflation is persistently below central bank targets.

I’ve argued before that it makes perfect sense those low yields have a profound influence on how shares are valued, especially for companies that offer higher levels of growth than the broader market. Whether it be through basing a discounted cash flow valuation on lower risk-free rates (bond yields) or the return premium offered by stocks over bonds, lower yields drive higher share prices.

Inflation’s effect on valuation

Given we’ve never seen a mix of yields and inflation like we’re seeing now, using historical references as your only valuation anchor makes no sense. A more convincing concern is the potential return of inflation because that will fundamentally change the valuation landscape, but there is no one who can give you a definitive answer as to what drives inflation. You need only look at the Fed’s ‘dot plot’, which started back in 2012 and records where each of its 12 board members and seven presidents think inflation and interest rates are headed. Despite having the best information available, and apparently being the best qualified in the US, they’ve never been close to right.

Another thing that has driven valuations on the US market up is that so-called ‘growth’ stocks, which are those companies whose earnings are growing faster than the index and therefore usually trade on higher PE ratios, have increased from 15 per cent of the overall index in the 1970s to now 77 per cent. By contrast, ‘value’ stocks, which rely more on general levels of economic growth and trade on lower PEs, account for commensurately less of the index.

In terms of the economy being terrible, recent economic data suggests otherwise. Like Australia, the US government injected about 13 per cent of GDP in brand new money in the form of COVID support, money that has to go somewhere. Sure, GDP fell 31 per cent in the March quarter of 2020, but it rocketed up 33 per cent in the June quarter. Business confidence is close to its equal highest in the last 25 years, unemployment is not far off its average for the post GFC/pre-COVID period, house prices are at an all-time high and there has been a record number of US companies upgrading earnings guidance in the first quarter. And the new Biden administration is preparing to spend another $1.9 trillion.

Lessons to be learned

By his own admission, Grantham’s past calls have typically been early. Getting out of Japanese and US stocks two years before the market peak cost his firm’s investors about 60 per cent each time. That offers a couple of salutary lessons. First, timing market tops is really challenging, especially if you rely on valuations to do it. And second, even if you’re worried about a market looking toppy, you don’t have to sell out of it entirely. You can simply reduce your holding gradually as it rises and switch your money into an asset class or market that doesn’t look as stretched, such as Australian, European or emerging markets shares.

There are undoubtedly pockets of the US market that look extreme right now, especially the speculative end of retail investors, but even that doesn’t apply to the whole market. When billionaires make bearish calls it’s hard to overcome our innate human bias that prioritises self-preservation and sees pessimists as smarter, but for your portfolio’s sake, it can pay to look for context.

What are the prospects of a post-COVID boom?

What are the prospects of a post-COVID boom?

This article appeared in the Australian Financial Review.

After news of a promising COVID vaccine hit financial markets on 9 November, those sectors that had been shunned like last week’s fish dinner while economies were at risk of ongoing lockdowns suddenly became flavour of the month.

Investors pounced on the stocks that should benefit from people returning to ‘normal’, which saw sectors like energy, banks, retail property trusts, hospitality and travel shoot up. At the same time, the companies that had starred during lockdown, that benefited from people shopping, working and exercising from home, surrendered some of their astonishing gains.

This has left smart investors facing the usual challenging questions: has the market already priced in the return to normal? Should you be erring on the side of caution and selling into these strong markets?

We continue to advise clients to remain fully invested in the allocation to growth stocks their risk profile allows.

Strong outlook for the economy

There are several indicators pointing to the possibility of a strong economic environment in the year ahead. First, the Australian government injected stimulus equivalent to 13% of GDP in the form of JobKeeper, JobSeeker and other direct payments. The $34 billion worth of early super withdrawals added another 2.5% to that.

A lot of that stimulus has already been spent, which was the whole idea, but much of it has been saved, with Australia’s household savings ratio hitting 19.8% in the June quarter, almost eight times higher than a year ago and only 0.5% below its peak of the last 60 years. That’s a serious amount of spending power.

And spending is exactly what it looks like Australian consumers are doing after confidence levels jumped to 10-year highs. The Commonwealth Bank reports its credit card data showed spending in the week to 13 November was up 11% compared to last year. Restaurants in New South Wales enjoyed seated dining numbers 55% higher than a year ago, while Queensland was a whopping 79% and even shellshocked Victoria was up 54%.

Retailers will be eyeing off that pool of savings in anticipation of a bumper Christmas and companies in general should expect a lot of that money to work its way around the economy for a while yet.

The US is in a similar position, with a 13% stimulus package pushing the personal savings rate to almost double what it was at the start of the year. Although a fresh stimulus package has been trapped in a political standoff for the time being, it is expected the new Biden administration will make it a priority. Meanwhile, record low interest rates have ignited the housing market, with home values at record highs, homeowners’ equity at record levels and monthly new home starts challenging their all-time highs.

If the new vaccines are as effective as they appear, the Chinese economy has shown how quickly things can bounce back. China’s manufacturing and services sectors have rebounded strongly, pushing annualised GDP growth to 5% and retail sales are almost 5% higher than a year ago.

What about the markets?

Whoever would have thought the US share market would already be at a record high the day a COVID vaccine was announced? Let alone that it would hit that high amidst COVID cases being reported at record rates across the globe. And that strength is being seen in stock markets around the world, with 52-week highs in China, Europe, the emerging markets and even Japan is at 30-year highs.

2020 has been a great reminder that share markets do not necessarily follow economies, so it’s entirely possible we will see an economic rebound and poor markets. And there are plenty of sceptics ready to point to elevated valuations as a warning signal.

So how do those valuations stack up? Australia’s ‘forward PE (price to earnings) ratio’, so based on earnings forecasts for next year, is at 19 times compared to a 32-year average of 14, and the MSCI World Index is at 21 times compared to 16.

On the face of it, that makes shares look pretty expensive. However, I’ve argued for a long time that low inflation supports higher PE ratios. 30 years ago, Australia’s inflation rate wasn’t far off 10% and it’s been trending downwards ever since. So, with inflation currently below 1%, it makes perfect sense that the PE ratio would be higher. In fact, comparing today’s PE ratio to any period as far back as 40 years ago, when inflation peaked at close to 18%, is like comparing the proverbial apples and oranges.

Further, high growth companies such as the tech sector have defied any gravitational pull of lower PE ratios. I’ve argued before that it makes little sense to value a software company whose earnings can grow exponentially without requiring any further capital outlay the same way you’d value a company whose earnings can only grow in proportion to how much they spend on building new factories.

Bond yields have also been steadily declining and, likewise, it’s well established that falling bond yields underwrite higher equity valuations. The typical way to value a share is by working out what a company’s future cash flows are worth today by applying a ‘discount rate’, which is normally based on the 10-year bond yield. The closer bond yields get to zero, the more valuable are those future cash flows in today’s money.

With interest rates at levels designed to punish savers and prospects of a vaccine unleashing a post-COVID spending spree, it’s little wonder global equities just saw the biggest week of inflows ever. Now is not the time to be sitting on cash.

Want some help with your investments?

To discuss how we can help call Steward Wealth today on (03) 9975 7070.

Why hybrids offer defensive potential but have strings attached

Why hybrids offer defensive potential but have strings attached

This article appeared in the Australian Financial Review.

When the best term deposit rate you can get is below 1% from a bank you may never have heard of, the chance to get 4% or better on a hybrid security from one of the big four tends to grab your attention. The problem is, of course, those attractive rates come with all kinds of strings attached.

After emerging 25 years ago as a handy solution for companies to raise money and for share market investors to be able to access higher yielding securities, hybrids have become an entrenched part of the Australian market. However, while they can readily play a role in a smart investor’s well-structured portfolio, they are devilishly complex. There is a variety of structures and features requiring issuing documents that can run into the hundreds of pages, enough to prompt government websites like Moneysmart to describe them as ‘very risky’.

The ‘hybrid’ label is because they blend elements of debt securities and equities, that is, they are part bonds and part shares. Typically they promise to pay a rate of return, which you can think of as an interest rate, for a certain period of time, and at the end of that period, the investor gets the original face value of the security, which is normally $100, in shares.

The interest rate is usually quoted as a margin above the 90-day bank bill rate. Companies with a lower credit rating will have to pay a higher margin, just like a corporate bond. The rate can be fixed at a specific return, or it can ‘float’, meaning if the bank bill rate goes up or down, so too does the interest rate the investor receives. And hybrids commonly incorporate franking credits as part of the yield.

The rate a hybrid pays when it’s issued will normally be set by the issuer’s investment bankers going out to the market and testing investor appetite. Then once the security is trading on the market, the rate an investor receives will depend on the price they pay for the hybrid.

The part that makes hybrids complex and risky is the equity element. No two hybrids are the same, and the obligations of the issuer and the rights of the investor, can vary considerably. Some hybrids allow the issuer to stop paying any interest if it falls into financial difficulties, and some place the investor’s rights to recover their money in the event of the company failing behind all other creditors.

The theoretical price a hybrid security should trade at is determined by the combination of its starting margin over the bank bill rate, its different equity-type features and the length of time before it matures. The longer the time to maturity, the more time there is for something to go wrong and so the higher should be the interest rate.

The upshot of all these features is that hybrids are normally a lot more volatile than pure fixed income investments, but not as volatile as shares. When the ASX 200 fell 37% in February and March this year, the Betashares Active Hybrids ETF (HBRD) dropped by just over 15% and is now getting back to its pre-COVID levels, while the broader share market is still 14% below it.

Andrew Papageorgiou, a portfolio manager at credit investing fund manager Realm Investment House, said, “While hybrid prices do fluctuate, they are underpinned by solid mathematics. Like all securities, from time to time prices can be considerably above or below where we calculate they should be, which creates opportunities.”

This begs the question: if a self-directed investor doesn’t have access to the maths, how do they know when hybrids are cheap or expensive? The various stockbrokers that help sell new issues usually publish research showing the basic valuation measures, such as the current yield, and some of them may offer recommendations.

It’s worth bearing in mind, however, those brokers get paid commission to sell hybrid IPOs (an exception that was carved out from the recent reforms that saw LICs and LITs stop paying commissions), so there is an overarching question of conflicts of interest. There are other websites, such as yieldreport.com.au, that publish tables as well. Papageorgiou says a very rough rule of thumb is that normally bank hybrids, which dominate the Australian market, should generally trade at a margin of about 3.2 to 3.3% over the bank bill rate.

A few years ago Australia’s bank regulator, APRA, introduced clauses into bank hybrids enabling them to stop interest being paid or even to compulsorily convert the hybrids into shares if the bank’s senior equity falls below certain levels. ASIC expressed great concern that investors wouldn’t understand the risks and that hybrids were being marketed as an alternative to term deposits. To be clear, buying a bank hybrid is nothing like placing a term deposit with the same bank. A term deposit is government guaranteed (up to $250,000) and its value doesn’t change on a day to day basis.

However, asset allocation consultant, Tim Farrelly, argues the kind of market events required to trigger the conversion clauses are so extreme, and APRA is sufficiently vigilant, that investors shouldn’t lose sleep buying a bank hybrid provided they are comfortable holding it until maturity. That way they can ignore the market volatility and enjoy the added yield of a defensive, investment grade security. If you don’t think you can stomach the potential for 15% drops in the defensive part of your portfolio, no matter how temporary, then don’t go there.

Want to find out more about your investment options and whether hybrids could work for you? Get in touch today.