China and the consumer are huge headwinds for Australian shares in 2017-18 and a reason to focus portfolios on companies exposed to offshore markets.
It is hard to get excited about resource companies as more signs emerge that China’s private-and public-sector debt build-up is causing problems. Spot prices for iron ore are at a 12-month low this week and have further to fall, amid easing Chinese growth.
Australian banks face a mountain of challenges: rising regulatory risk, requirements to hold more capital, heavily indebted consumers, fears of a property correction and a potential rise in bad debt, to name a few. That’s a tough backdrop for bank stocks to outperform.
Then there is the struggling consumer. The Westpac-Melbourne Institute Consumer Sentiment Index, released last week, showed sentiment had fallen for three consecutive months and was almost 6% down from the same time last year.
Who would want to be a retailer when consumers are groaning under household debt, wages growth is at a record low and more jobs are being casualised? For good measure, Amazon looms on the horizon and international retailers are expanding here.
Take out resources, banks and consumer discretionary stocks and it becomes harder to find value in this market for FY18, particularly after this week’s sharemarket rally.
There are, of course, always opportunities in these and other sectors – every stock has its price. Miners such as South32 still look reasonable value and Evolution Gold is a standout in the precious-metals sector. Adding gold exposure in FY18 makes sense.
But there is an argument to reduce exposure to the slowly Australian economy and increase exposure to key offshore economies, through stock selection, in FY18. Our economy could skirt with recession in the next 12 months if consumer sentiment keeps falling.
Soft retail spending, a slowing housing cycle and lower commodity prices will be bigger drags on our economy in FY18 and weigh on company earnings growth and valuations.
On balance, Australian shares will probably drift higher in FY18 – my base case for several years has been a slow grinding recovery in the sharemarket as consumers restore their balance sheets.
But expect Australian equities to underperform global equities in FY18. A lower Australian dollar could further boost returns in global equities for local investors who are not hedged for currency movements.
This overseas theme flows through my four stock selections for FY18. I chose companies or funds with exposure to offshore markets (my brief was to identify Australian shares; investors seeking global equities exposure could invest directly or use specialist funds).
Like this time last year, I have identified a blue-chip, mid-cap, small-cap and micro-cap stock for this edition’s special report for the new financial year.
Amcor (AMC)
Amcor and Brambles Industries were tough to split as the blue-chip selection for this column. Both are part of a group of Australian companies that earn a significant amount of revenue overseas (others include James Hardie Industries, Computershare, Aristocrat Leisure, Westfield Group and Macquarie Group).
I included Brambles in the Switzer Super Report takeover column in late February [1] because it looked oversold. The stock has rallied from $9.29 to $10.47 since that column and has good recovery prospects given its sustainable competitive advantage in pallets.
Amcor looks a touch cheaper than Brambles and I like its exposure to improving European economies, which should be a tailwind for earnings growth. Western Europe accounts for about a third of Amcor’s revenue and a lower Australian dollar would boost the company.
The packaging group has excellent defensive qualities and its earnings resilience was again evident in the half-year result. Restructuring initiatives and an increase in packaging volumes are other medium-term positives.
A consensus of 11 broking firms has a hold recommendation on Amcor. That is too bearish. Amcor has had a decent rally since February, but has further to run in FY18 as investors pay a higher premium for its exposure to improving European markets.
IDP Education (IEL)
Were it not for this column’s overseas theme, I would have included the impressive Link Administration Holdings on the strength of its share-registry business and growth potential as small superannuation funds outsource their administration.
Instead, I’ve gone for IDP Education, a leading provider of international student-placement services and English-language testing services. The Melbourne-based company also owns and operates several English-language schools in South East Asia.
Sluggishness in Australia’s economy in FY18 is unlikely to affect continued strong demand from Asia for university education and English-language training. If anything, a lower Australian dollar should make our university sector globally more competitive.
The Federal Government’s proposed changes to the testing process for prospective Australian citizens should add to demand for English-language testing, as should changes to the temporary skilled migration program (457) around language skills.
I nominated IDP as one of four oversold mid- or small-cap stocks [2] for the Switzer Super Report in January 2017, at $3.92. IDP now trades at $4.93, continuing its stellar gains in the past few years. IDP has a terrific position in an attractive industry.
CBL Corporation (CBL)
The niche provider of financial-risk insurance has been among the better floats in recent years. The New Zealand-based CBL raised $114 million at $1.41 a share and listed on ASX in October. It has rallied to $3.26.
I outlined a positive view on CBL for this report (at $1.75) in November 2015 in an article on “3 mid and small-cap insurers to watch [3]”. That view still holds for FY18.
To recap, CBL’s key product, builders-warranty insurance, is popular in France. The cover indemnifies home owners against non-completion by the builder and protects against the cost of repairs. CBL focuses on smaller builders that construct a few houses each year, to minimise risk, and provides quotes much faster than its nearest competitors.
CBL has acquired Securities and Financial Solutions Europe SA, its major product distributor in France. CBL should deliver stronger growth in France in builders-warranty insurance and expand in Asia as it re-signs customers.
The company is well run and it is invariably a good sign when management has a large stake. Share-valuation service Skaffold estimates CBL’s intrinsic value at $5.55 in 2017, rising to $6.48 in 2018 and $6.99 a year later. This might be too optimistic, but CBL’s re-rating has solid foundations.
CBL looks like one of a small group of high-quality small caps with strong offshore exposure, and a valuation that still does not adequately reflect its future earnings growth.
PM Capital Global Opportunities Fund (PGF)
I wanted to include an ASX-listed fund that offers exposure to global equities rather than only Australian stocks with a high proportion of offshore earnings. PM Capital Global Opportunities also qualifies as the column’s micro-cap idea.
PM Capital Global, a listed investment company, is managed by PM Capital, one of this market’s better-regarded investors in global equities.
PM Capital has a contrarian bent. The fund’s high exposure to foreign banks (about a fifth of its portfolio a year ago) worked against it in 2016. Britain’s decision to leave the European Union weighed on European and US bank stocks, and on PM’s performance.
For all the volatility, comparable foreign banks look cheaper than Australian banks, Europe’s economy is improving and expanding credit growth and rising interest rates in the US should help bank earnings growth and valuations there in the medium term.
Patience will be needed. PM’s consistent long-term record in outperforming its benchmark index reinforces that investors need to stick with it through the cycles.
The LIC’s 12% discount to pre-tax Net Tangible Assets (NTA) based on its latest NTA, seems excessive given the manager’s quality and investment strategy.
Expect the gap between the LIC’s share price and NTA to continue narrowing in FY18.
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at June 14, 2017.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.