Rudi’s View: The Big De-Rating – A Guide Through The Minefields (3)

This story features AMCOR PLC, and other companies. For more info SHARE ANALYSIS: AMC

By Rudi Filapek-Vandyck, Editor FNArena

Sometimes the best tool at hand for an investor is his gut instinct. When troubled packaging company Amcor ((AMC)) announced the intention to acquire the Alcan Packaging operations from Rio Tinto ((RIO)) in August 2009 my attention was drawn. Up until that point the former market darling had been languishing for years, still suffering from corporate indigestion after numerous acquisitions and from the fall-out of proven illegal cartel collusion with Richard Pratt's Visy to keep prices artificially high for card board boxes in Australia. Any meaningful advance in earnings per share had ceased after FY03 and things weren't exactly looking splendidly post November 2007.

This acquisition, however, had the potential to finally allow the company to break out of its slump to nowhere, because of the synergies that were available once ownership of the former Alcan businesses had been achieved. I am usually very apprehensive in getting excited about businesses on the basis that they are buying others and very well aware of numerous research done throughout the years concluding more often than not, the only ones genuinely profiting from such deals are the shareholders of the acquisition target, and only them. But in the case of Amcor-Alcan Packaging I was sold, predominantly because I realised this deal would change Amcor's outlook.

All of a sudden, the future for Amcor had turned into a scenario that promised "growth", something not seen since many years for the company. I knew such a turnaround had the potential to trigger a re-rating, which meant the low double digit Price-Earnings (PE) ratio should rise, virtually guaranteeing above average investment returns. I have not been disappointed on this assumption. Amcor's PE started off around 11 in 2009, has subsequently risen to 16 and today, as the share market is trading on an average PE of circa 12, Amcor's is still well above 13.

Equally important is the de-rating post 2003 had made Amcor shares a relatively attractive dividend yielder (5-7%). At the time, I was aware of the general de-rating that was taking place in equities around the globe, but I hadn't as yet connected all the dots just yet as to which stocks would continue to thrive in this new environment. What I had already figured out was that dividends were to become the new treasure for investors, and the best way to play dividends in the share market is by combining them with growth.

Has Amcor been a success? Let's have a look into the finer details…

Amcor's share price performance prior and post the Alcan Packaging announcement is remarkably different; a transformation from going nowhere in a hurry to grinding steadily higher, in line with a refound growth profile. Dividends have increased every year and by mid-teens percentages. The share price has appreciated some 40% in a little over two years (note there's an above market dividend yield on top of that) and as I write today's story the ASX200 index is still down more than 8% since the start of this calendar year, yet Amcor shares are up more than 5%. Add 5.6% in prospective dividends (consensus estimate for FY12) and, assuming no sell-off will occur anytime soon, Amcor should generate a double digit return for loyal shareholders at a time when most stocks in the ASX200 will struggle to offer a positive return for the calendar year.

So what's Amcor's secret? After all, BHP Billiton's ((BHP)) profits have risen much steeper in years past while Australian banks pay much higher dividend yields, and fully franked too, yet their shareholders have by far not enjoyed similar returns!

To answer this question we have to travel to the US where every funds manager and investor knows what to do in times of trouble: seek shelter in names such as The Coca-Cola Company, McDonald's, Colgate-Palmolive, Johnson & Johnson, Phillip Morris, Wal-Mart and Procter and Gamble. With the exception of McDonald's and Phillip Morris, none of these household safe-havens has performed spectacularly good or bad since November 2007 (both PM and MCD have performed spectacularly well), but these stocks have a persistent habit of not losing money for shareholders.

Warren Buffett is a long time shareholder in Coca-Cola and he only sold his shares in Johnson & Johnson in 2009 to participate in highly attractive bailouts for Goldman Sachs and General Electric that year. As an indication of the type of "security" we are dealing with here: Johnson & Johnson has consistently raised dividend payouts, without interruption, for 49 consecutive years. Procter and Gamble this year raised its annual dividends for the 55th year in a row.

Occasionally, these companies do run into a disappointing year, like Coca-Cola in 2009 when its adjusted earnings per share fell by 3% in comparison with the previous year, but the company has made up for it through annual growth above 10% since. Prospects for the years ahead are for more of the same. Analysts at Citi recently commented in their analysis post yet another market update: "This is what defensive (and good execution) looks like".

These companies are listed in the US, but they are not US companies. Each of them is a global giant with operations in many more countries than just the US. On top of this geographical spread, revenues come from staple products, not some high tech gadget that can easily be left out of the household budget when things get tougher, or from a highly volatile natural resource of which the price dives and jumps with every new development in Emerging Countries. The key words that come attached with each of these safe-havens is "confidence", "consistency", "reliable" and "a proven track record".

All these additional conditions come on top of the usual requirements that make for an attractive investment proposition, including a reasonable share price, manageable levels of debt, positive cash flows, high return on equity plus growing profits and dividends.

In other words: when things get really tough, investors want maximum safety and security. The higher the safety, the better. If risk appetite disappears for extended periods, any potential source of weakness turns into a liability that is best avoided. In Australia's case, BHP Billiton may have grown its profits much faster, but as things turn more challenging this simply opens up too many unknowns lurking around the corner: what's going to happen to commodity prices? What's going to happen to demand? What's going to happen to capital flows? What will returns be on those massive capex projects? Too many unknowns for any level of comfort!

Unfortunately, most share markets outside the US don't have such a variety in safe-haven options available. Other markets are happy with having one or two comparable options, such as Unilever in Amsterdam and Nestle in Zuerich, but most have none. In Australia, the company that probably comes closest is Coca-Cola Amatil ((CCL)). The company is linked to Coca-Cola in the US, which provides key product licenses and is also a cornerstone shareholder.

Under different circumstances Woolworths ((WOW)) could have been a good second choice, but not this time around. As I explained in earlier writings, Woolworths is still going through a de-rating process which has translated into a gradually lower share price. An extra weakness for Woolworths is that consumers in Australia, similar to other developed economies, are going through a deleveraging process, which hurts operations such as Big W and Dick Smith, while New Zealand's economy has proved a drag too. Coca-Cola Amatil has more exposure to consumers outside Australia and New Zealand with soda drinks, bottled water and canned foods proving a resilient offering.

The evidence is there for anyone to see in Coca-Cola Amatil's share price performance in recent years. Even better than many a safe-haven example in foreign markets mentioned earlier, Coca-Cola Amatil shares are trading circa 20% above price levels of late 2007 and they pay a nice dividend (4-4.5%) on top. The shares are in positive territory for the year 2011 too.

One big, widely held misconception in Australia is that healthcare stocks are defensive too. This may be the case in the US where companies such as Johnson & Johnson sell vital products and medicines to governments and hospitals around the world, alas in Australia most healthcare stocks had prior to 2008 become high PE multiple stocks with negative leverage to the Australian dollar. The combination of these two characteristics has proved too much liability for most stocks involved. Think ResMed ((RMD)). Think CSL ((CSL)). Think Sonic Healthcare ((SHL)).

There has been one notable exception, though, and that is private hospital operator Ramsay Healthcare ((RHC)). Just to illustrate my point: CSL shares held their own in 2008, but they have lost circa 30% since, while Ramsay shares are up more than 60% over the same period.

Note the ASX200 is (November 2011) circa 40% lower than where it was in November 2007.

One other healthcare stock that looked like it was going to perform as well as Ramsay was Cochlear ((COH)), until the company announced a sudden product recall in 2011 after which the stock received instant capital punishment.

The examples of Ramsay and Cochlear are important, in my view, as they prove that "healthcare" as a sector has not received the same treatment as sectors such as "consumer discretionary", "old media", "property" or "financials"; all these latter sectors have been ruthlessly de-rated regardless of any qualities for individual companies in these sectors.

What has happened in healthcare, or so it seems in hindsight, consists of a succession of individual weaknesses and de-ratings that looked like the sector as whole was being de-rated, while in practice investors were witnessing the stumblings of high PE multiple stocks that could no longer justify and carry the valuation premium.

What we've learned so far is that it is still possible to research and pick stocks that should perform well, both through share price gains and growing dividends, but it has become a whole lot more difficult to confidently find suitable candidates. Apart from individual investment qualities, it has become paramount to also include an assessment of the "sector" in which the company operates, as well as an anticipation of how much confidence other investors adhere to the specific investment qualities and the growth path ahead.

There are plenty of examples around of companies that carry many good qualities, including strong growth in profits, but their share price performance has been rather disappointing as average PE ratios declined and risk appetite subsided. Incidentally, I consider this as yet another prime reason to only pick stocks that offer a healthy dividend yield. In case the execution won't be perfect and, despite diligent research and analysis, one happens to pick a stock that is not being recognised by other investors as being equally "solid and safe", at least there will be growing dividends while investors await the return of risk appetite, and of better times.

More lessons are to be drawn from the list of stocks I released in October of 2011; ten stocks that are all up since the start of the year, as well as since November 2007. Those ten stocks are:

– Campbell Brothers (CPB)
– Domino's Pizza ((DMP))
– ARB Corp ((ARP))
– Blackmores ((BKL))
– Reckon ((RKN))
– Ramsay Healthcare ((RHC))
– Mc Millan Shakespeare ((MMS))
– M2 Telecommunications ((MTU))
– Hansen Technologies ((HSN))
– Coca Cola Amatil ((CCL))

With the exception of Hansen Technologies and M2 Telecom, these companies have consistently been on my radar post 2008. Regular readers of my writings will recognise most names as they appeared now and then in my stories and analyses. As it was pointed out to me recently, the compound total investment return for all ten stocks is more than 100% for the past five years (which means shareholders have at least doubled their original investment in only five years).

Investors should be careful when taking this list into consideration, as some of these stocks are no longer cheap, and look quite expensive instead. Think Domino's Pizza. Think Ramsay Healthcare. Think Campbell Brothers.

Analyse these stocks and you may find yet more clues as to why these are the types of stocks that should be considered for any long term investment portfolio. Each of them has proved it can perform throughout the most challenging of times.

P.S. Note Computershare's acquisition of the BNY Mellon share registry operations will likely have the same impact on the company's future as what Alcan Packaging did to Amcor in 2009 (though with a different risk and valuation profile. Amcor operations are much more defensive).

The above story is the third in a series titled "The Big De-Rating – A Guide Through The Minefields". The fourth story will focus on a specific category of stocks that should be on investors' radar, likely to be published next week.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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