Wear Two Hats. Don’t Mix

This story features TELSTRA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: TLS

By Rudi Filapek-Vandyck, Editor FNArena

There is little reason to question the fact that if equity markets were fully guided by the trend in economic data since November, the performance off the trough in September would have been even stronger. Not that investors have much to complain about, at face value. US equities are up by more than 20% over the period. Most commodities have had a good run. The Australian dollar is back at US$1.07-1.08 and the ASX200 index is up by nearly 11%.

Problem is, however, while momentum traders are having a good time, most investors have stoically remained absent from this market rally, poor transaction volumes supported by anecdotal evidence shows. (In addition, the FNArena/AIA Investor Sentiment Survey for January also supports this observation).

Digging deeper into local share market action shows ongoing ambivalent attitude from investors towards the recent surge in overall risk appetite. How else can we explain the fact that Real Estate Investment Trusts (REITs) outperformed the broader index thus far into 2012? These are the types of securities that should underperform instead when global economic data turn for the better and herald the return of more appetite for risk-taking. In addition, shouldn't we all abandon dividend-heavyweight Telstra ((TLS)), or the maximum safety of InvoCare ((IVC)), or the profit growth security of Domino's Pizza ((DMP))?

Instead, these stocks are trading near their highs for the year, well above consensus price targets and on Price-Earnings (PE) multiples usually reserved for high growth stocks during good times, or for ultra-defensives during times of severe distress. To prove my point, I might as well add the likes of Australian Pipeline Trust ((APA)), Spark Infrastructure ((SKI)) and SP Ausnet ((SPN)), plus many others, to this list of highly sought after providers of yield and capital protection.

Needless to say, the world remains divided as to how and where best to park one's investment funds. The obvious conclusion is to draw a direct connection with ongoing uncertainties and risks related to Europe. Another equally straightforward assumption to make is that traders -being market participants with a shorter term, volatility-centred focus- are more likely to trade in and out of the riskier, cyclical stocks. This then leaves the likes of InvoCare  to the longer term investors?

Yes, indeed, while most experts and commentators seem to be focused on what might happen with this year's rally in the immediate future, there is another strong trend emerging in the background which as yet is not receiving much attention: the global search for yield.

There are plenty of reasons to support this search; the shrinking pool of AAA-rated government bonds worldwide, lower returns achieved from equities, the generational shift in demographics (Baby boomers are retiring now), the gradual realisation the present re-adjustment process post an incredible credit binge has much longer to run which is likely going to weigh on future returns from equities, comparisons with 1964-1982 and with the thirties are becoming more mainstream suggesting while equities can go up in the short to medium term, they also can easily come down again below today's levels a little further down the track.

Within this framework my recent research has revealed one mighty surprise which I am certain will surprise many among you (if not ALL of you).

Inspired by the fact that total investment returns on shares in CommBank ((CBA)) since the peak in late 2007 (at the pinnacle of the Great Big Bubble) are now positive if we include all the dividends paid out by the bank to loyal shareholders, I thought let's draw up a comparison with the world's largest resources stock and biggest member in Australian stock indices, BHP Billiton ((BHP)).

Note that not only have Commbank shares recovered more since their 2007 peak (down 18.5% versus down 22% for BHP shares), they also performed better since their respective troughs in March 2009, and since early 2010, and since early 2011. As a matter of fact, Commbank shares are even slightly ahead thus far in calendar 2012 (without the dividends)!

CommBank pays a big, solid, growing and likely sustainable dividend twice each year. BHP's dividends equally look solid and sustainable, but -in yield terms- they are less than half CommBank's.

The end result is that the one representing the beaten-down financials sector, source of all troubles in today's world, has generated a better investment return on virtually all key time horizons since late 2007 compared with the one representing the new boom era for natural resources on the back of a developing China. And, of course, it all comes down to two key features: big, sustainable dividends and the (new) habit of equities to return to previous low price levels instead of surging continuously like in the years leading up to late 2007.

There is a message hidden in these observations, and it is a very loud and clear one for longer term investors: know what you want. Short term momentum and longer term returns do not necessarily mix.

Incidentally, I have been advocating since 2009 that investors who actively manage their own investment portfolios should wear two hats: one is the hat of the long term investor, focusing on capital preservation, sustainable and growing dividends and on "all-weather performers" at reasonable prices, while the second hat is of the shorter-term, momentum oriented trader, seeking the best opportunities in line with ruling market sentiment.

I'll leave it to investors' own goals and risk appetite to decide how much should be allocated to each hat, but the warning remains and has remained the same: don't mix up the two. They're water and oil. Ice and sunshine. Chocolate and salmon. Once you start mixing one with the other you are setting yourself up for major disappointments and potential capital losses (mix chocolate and salmon and you risk food poisoning).

As far as the outlook for equities is concerned, a lot will be decided by economic data and indicators in the weeks and months ahead. We don't know yet how credit tightening by European banks will impact on economic activity in the weeks and months ahead. There is as of now no evidence liquidity pumping by the ECB is actually leading to new credit creation by these banks (instead there are plenty of observations that credit is probably shrinking instead). In addition, economic data since November have been much stronger than expectations. In fact, they have been so strong that many an economist has been forced to adjust projections for 2012 upwards.

Can this last?

I remain of the view that much of the upward surprises can be explained by the unusually mild weather in November, December and January in the Northern Hemisphere. How much of an impact exactly is impossible to guesstimate, which is why PMI outcomes in the months ahead will be crucial for the duration and sustainability of 2012's rally in risk assets (along with other leading indicators). However, it is likely that as long as the general picture remains in place of economies stabilising and turning the corner, equities, commodities and other growth-leveraged risk assets will continue to perform well.

There are plenty of supportive arguments for such a continuation. Global earnings downgrades seem to have troughed with the rate of reductions slowing down significantly (but NOT in Australia). Equally, when manufacturing and services PMI surveys stabilise and turn for the better, this often coincides with the most profitable time for equities and for commodities. Analysts at JP Morgan have calculated the ideal time to own equities is when the US services PMI survey reads in between 50-55, which is now. Analysts at Macquarie combine the OECD Leading Indicator with global earnings forecasts to predict the most profitable time to own equities is right now. Analysts at Deutsche Bank have observed the Australian share market usually outperforms its US peers during local reporting seasons in February and in August (odds of 80%).

The key problem for Australia hasn't changed, though. Average growth in earnings per share shall print somewhere close to zero this month, while forecasts for FY13 are overshadowed by the ever so strong AUD. Goldman Sachs has proved the first to raise in-house currency forecasts to US$1.08 for the foreseeable future. Expect their analysts to come out with sharply reduced estimates the coming days and weeks. Hardest hit will be exporters in the paper and packaging sectors, in healthcare, in chemicals, insurers and developers and contractors.

Note: on FNArena's calculations the average value for AUD/USD has risen to 1.05 on a one-month's basis and to 1.049 thus far this calendar year, so GS is clearly trying to be pro-active.

Ironically, the 100% hardest hit will be resources companies as their products are priced in USD, but Goldman Sachs observes, rightfully so, that market sentiment allows share prices of resources companies to move in synch with the currency as both are treated as a leverage of global growth and risk appetite. To a long term oriented investor, this doesn't make much sense (unless the AUD lags). Maybe this is yet another signal that when it comes to investing in the share market, ultimate success and performance all boils down to that one key question: know what you want. Once you know, then find out how you are going to achieve it.

Whatever you do, don't mix short term with long term as -outside the good ol' bull market- both strategies require different species that are destined to disappoint when bought by the wrong hat.

(This story was written on Monday 13 February 2012 and published on that day in the form of an email to paying subscribers at FNArena).

P.S. Subscribers are advised to read my e-booklet "The Big De-Rating. A Guide Through The minefields" to find out why I think "all-weather" performers are the preferred choice for long term investment objectives. If you are a subscriber and you haven't received your copy, send an email to info@fnarena.com

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