Avoiding investment potholes

If there is one pattern emerging in portfolio management, it is that avoiding the resources sector has benefited investors as much as choosing to invest in other sectors such as technology, healthcare, and infrastructure. 

If there is one underlying theme currently running through funds management, it is that it is as much about what you omit as it is what you include. 

So far, 2016 has seen oil prices plummet to 12-year lows of US$30 ($39.99) in the first quarter, before settling at US$48.13 a barrel when this article went to press. But that was not before it reached a 2016 high of US$48.50.  

Iron ore plunged to $US38.30 last year, but recovered to sit at US$66.24, but not before topping US$70 the week before this article went to press for the first time since January 2015. 

Australian equities – digging out of resources 

Fund managers have become wary of investing in the resources sector due to this volatility, with bottom-up investors, Hyperion Asset Management, recently deciding to exit its minor position in BHP Billiton, meaning the firm now has zero direct exposure to the resources sector, in contrast to the benchmark, of which the sector represents around 17 per cent. 

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The firm said BHP Billiton will face structural headwinds in the future, has limited control over its revenues, is vulnerable to commodity prices, and operates in a capital-intensive sector. 

Hyperion portfolio manager, Jason Orthman, said resources had been sold down for many years, and believes this is not sustainable, and added that the firm was after high organic growth businesses during a prolonged period of low interest rates and subdued growth levels. 

"We've really seen that during the GFC [global financial crisis], the entire stimulus that's being thrown at the world hasn't really significantly worked: growth rates are still subdued, the consumer's still subdued and we expect the cycle just to grind sideways for a long time," Orthman said.  

"You're not going to get free kicks from stimulus from either fiscal or monetary policy to actually drive earnings. You actually need businesses that are taking market share." 

On the home front, Hyperion was attracted to companies like Starbucks due to its digital and loyalty programs, and Domino's Pizza, which was continuing to grab market share on the back of its low price pizza deals, and technology offerings like GPS data tracking, which has effectively targeted millennials. 

The firm also invested in classifieds like realestate.com.au, part of the REA Group, and SEEK, where money flowed from papers to the digital verticals and the website.  

It also expected to benefit from the ageing population, which would demand higher levels of care and services from hospitals. It was investing in healthcare through exposure to Health Scope, Ramsay and Cochlear. While Cochlear has penetrated deeply in infants, Orthman expected this to seep into the adult population as it ages. 

Advisers and fund managers cannot keep chopping and changing asset class allocations and entering and exiting sectors to keep pace with market movements, Commonwealth Bank executive manager, research, Aman Ramrakha opined. 

In his conversations with advisers, Ramrakha noticed that advisers were altering their expectations from asset class returns over a period of one to five years in light of a subdued growth environment.  

"From an asset class it's almost impossible to try and pick some of these and rotate portfolios across asset classes over a short period of time," Ramrakha said.  

"Particularly for advisers, there's a natural administrative barrier in the context of looking to transact through an advice process, move around client's portfolios and things like that." 

But Ramrakha said that when managers made the wrong call on stocks, it led to significant dislocations in unit prices, which then caused extreme events in portfolios. 

"A lot of managers are focusing on risk management and selling disciplines to ensure that if they get something wrong they can adjust to it far quicker than they have in the past," he said. 

"Something that's been a theme for a while in terms of our conversations with portfolio managers is that there's just a lot more focus on the downside of what could go wrong in a portfolio." 

Ramrakha echoed the view that investing is more about what you leave out than what you include. 

He said Australia was seeing moderate success in transitioning from mining to sectors like building and housing, and healthcare. Managers were also focusing on services in tourism as China sought to rotate from capital expenditure to consumption. 

Montgomery Investment Management chief executive, David Buckland, was pessimistic about Australian equity returns, noting that it had produced a dividend return only for the last couple of years. 

"Clients are after growth and as we know interest rates around the world are at record lows. And this is causing huge anxiety for people who have retired because they're earning very little on their hard earned savings," he said 

The firm was steering clear of the resources sector, labelling it a price taker, with little control over the price it receives. Instead it was focusing on stocks like RESMED, realestate.com.au, Challenger Financial Group, and TPG. 

Infrastructure – solid foundation, reliable demand 

Like other asset classes, infrastructure investment is as much about what is left out as it is what is included. 

From an investment perspective, infrastructure is an essential asset that will face reliable demand over time, regardless of the state of the economy, and there are between 200 and 250 assets on global stock exchanges that broadly meet that definition, according to Magellan Group's head of investments and portfolio management (infrastructure), Gerald Stack. 

However, while assets can face reliable demand, they do not necessarily have reliable cash flows. This could either be due to the fact that their revenue and earnings are linked to commodity prices, they face intense competition, or they come with sovereign risk issues. 

"Of the 250 stocks, what we at Magellan do is apply a test that says if you're going to call an asset infrastructure, a minimum of 75 per cent of their earnings have to come from assets which are essential and face reliable demand," Stack said. 

"But they actually generate cash flows that are incredibly reliable over time and they're reliable because they don't face issues that I've talked about." 

Magellan has screened out investment options like master limited partnerships, which transport and store oil and are toll-road type businesses. Although they collect tolls irrespective of commodity prices, plummeting oil prices resulted in considerable decline of their shares. Demand for transportation and storage declined as producers cut production in the wake of falling oil prices. 

Magellan also refrains from investing in Chinese infrastructure due to fears of sovereign risk despite the availability of strong opportunities in areas like aviation. 

However, it is investing in regulated utilities, airports, toll roads, communications infrastructure like mobile phone towers, and ports. In Australia, it is seeing strong opportunities in companies like Transurban, Sydney Airport, and Spark Infrastructure.  

"Sydney Airport is an exceptionally well-managed company, and benefits from the significant increase we've seen in Chinese tourism over time. Chinese travellers to Australia have grown in the last year at approximately 25 to 30 per cent," Stack said. 

Globally, there are about 140 companies that meet Magellan's investment criteria, with around 50 per cent of its investment universe relegated to the US, and 40 per cent to Europe, of which a quarter is in the UK. 

Global equities – it all depends on the Fed 

The US Federal Reserve raised interest rates from near zero levels for the first time in almost a decade, in December last year, while it decided to keep rates on hold in March at between 0.25 and 0.5 per cent, citing global market volatility, low oil prices and concerns about China's economy. 

Magellan deputy chief investment officer and portfolio manager for the global fund, Dom Giuliano, said there was a divergence in opinion about where interest rates will sit in three years' time, which was creating uncertainty around where investors' asset pricing will sit, particularly for long-dated assets.  

While the Fed was predicting rates would be around three to 3.75 per cent in 2018, the market was predicting it would be two per cent lower than that. 

"That's actually a really big difference because if you work through the math, you have to add a term premium to the Fed fund's rate to get to a longer-term rate," Giuliano said.  

"For a 10-year margin, you might add two per cent so the Fed fund's rate of three per cent might translate to a 4.5-5.5 per cent 10-year bond yield whereas the markets are saying it might be 2.5 per cent less than that." 

"That is a really big deal because that changes the evaluation of long-dated assets by 20 to 25 per cent." 

What that means for high quality global equities around the world like Nestle, Unilever, P&G and pharmaceutical companies is that their price to earnings levels are now at 21-22 times, whereas over the long-run, these companies have typically traded at about 16 times, Giuliano added. 

This means that if interest rates do reach 3.25 per cent by the end of 2018, equities have been severely mispriced by markets at present. 

"If the Fed's right and the markets are wrong, over the next two to three years, you should expect continued volatility and you should expect those asset classes which have benefited the most from very low rates of interest over the last half decade, to be the ones that are potentially the most impacted on the downside," Giuliano said. 

The technology sector continued to exhibit strong growth prospects and it included companies like Microsoft, Apple, and Oracle. Payment companies like VISA and Mastercard were also beneficiaries of tailwinds of people transitioning from using cash and cheques to plastic and electronic payment modes. 

"The companies that I've mentioned are all domiciled in the US but it's important to recognise that a very large portion of their earnings are earned from offshore," he said. 

China – work in progress 

The transition from fixed assets to consumption-led growth is going to take a long time in China, which has a very unbalanced economy at present. 

China has changed some of the policy settings to be more accommodative to monetary policy to encourage people to borrow but this is not something that is sustainable over the long-term. 

Giuliano said the Chinese government was also contemplating policy changes in areas like taxation, education, healthcare, and social security in order for citizens to feel more secure in their social standing and their ability to sustain themselves. 

"It means that they can save less and consume more. The Chinese are very big savers and that's something the Chinese government is aware of and they're seeking to address," he said.