“Sell everything except high quality bonds”. This is going to be a “cataclysmic year”.
This was the advice that UK investment bank RBS screamed to its clients in January.
While we could just stop at noting that RBS is no doubt the deserved winner of the gong for the worst call of 2016, the advice is interesting for three other reasons. Firstly, that it got such extensive media coverage in Australia by the likes of the ABC and Fairfax highlights that “bad news” sells. The fact that it was so wrong demonstrates again that you can’t afford to pay too much attention to headline grabbing analysts, investment banks, media commentators or other so called gurus. But also, it reminds us that 2016 has been a remarkable year for the stock market, which is finishing so different to the way it started, almost incomprehensibly different.
So, what are the big investment lessons from 2016, and can we expect a repeat of these again in 2017? Here is my take.
Lesson 1: Diversification
The most important lesson from 2016 was a strong affirmation of the case for diversification. That means diversification across the sectors and market components.
Because the year was such a turnaround – from outright pessimism about commodities and commodity stocks in January/February to a raging bull market in commodity stocks in November/ December – from enthusiasm for the interest rate “defensives” to the sell off for these bond proxies later in the year as bond yields surged – from banks being on the “nose” to regaining favour later in the year – from health care stocks being in favour to out of favour – if you didn’t have some exposure to most sectors, you’re year could have turned out quite horribly.
Let’s review the data to make the point. Year-to-date, the Australian sharemarket has returned 9.0%. In the first six months to 30 June, it added 1.1%. But as the following table shows, sectors such as health care, real estate, utilities starred in the first six months. Financials, the largest sector, was down by 5.4% for the first half. However, this sector is now on par with the overall market and is up by 8.5%, meaning that all the gains have come in the back half of the year.
Health care has had a horrible final quarter, giving back all its earlier gains. Similarly with real-estate.
Materials, which were so out of favour in January/February, as commodity prices crashed and the market discussed the prospect of receivers being called into major miners and the banks’ looming bad debt exposures, is the best performing sector of the year – up a staggering 38.6%.
The same is also true of the components of the market. After a horrid start, the top 20 stocks have roared back into life. The midcap 50, stocks number 51st to 100th by market capitalisation have done better, but smaller stocks have lagged the market over the last six months. The small ordinaries index, which represents stocks ranked 101st to 300th by market capitalisation, is on par with the overall market, with a return of 9.2%. However, this comes after a very strong first six months.
It’s not to say that you shouldn’t have portfolio biases. Of course you should – but they should be considered and periodically re-assessed, and of course, appropriate to your particular needs and objectives. In the case of the major sectors, being underweight a sector doesn’t necessarily mean having no exposure. For example, the materials sector makes up about 16% by market weight of the S&P/ASX 200. You can be underweight this sector, perhaps because you don’t like commodity prices or the low dividend yields don’t suit your investment objectives, and still have say 5% of your portfolio in leading materials’ companies.
The case for diversification is about risk minimization, minimizing the risk of material underperformance. Because the unexpected happens, we can reduce the impact of events (in many cases, just a change in market sentiment) by having a broader exposure.
Lesson 2: Buy quality in the doom and gloom
BHP at $14.06 on 21 January, now $25.00. South32 at $0.87, now $2.61. Fortescue at $1.44, now $6.30. Sure, these are all resource stocks – but try some of these financials. Macquarie at $58.38, now $87.54 – a rise of 50%. Or from its post Brexit low of $67.00, a rise of 31%. Or Challenger Life, now at $11.13 – up from a low of $6.58 – a rise of almost 70%. What has the distribution and sale of annuities ever had to do with commodity prices?
I could go on.
If a company has tier one assets, leading market share, unique customer proposition, track record of delivering on profit expectations, then use market “doom and gloom” events and bouts of extreme pessimism as a chance to buy. The quality stocks are always the first to recover. As Warren Buffet has said: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
Lesson 3: Beware the high PE stock
Investors in Bellamy’s, Blackmores, Vocus, TPG etc. and some of the “lithium stocks” probably don’t need any reminder of this lesson – but beware the high growth, high PE stock. Beware the latest investment fad.
If a stock is trading on a high multiple of forecast earnings, then the market is already paying a premium to access these earnings. By definition, this means that it is higher risk. That doesn’t mean that you shouldn’t buy higher PE stocks, it just means that you should apply a higher degree of care. Ask yourselves these questions:
- What is the track record of management in leading high-growth companies?
- What is the track record of management in meeting profit forecasts/exceeding market expectations?
- How much of the “growth” story is built on the back of acquisitions?
- If you are investing in a new technology or industry, where in the hype cycle are you?
- What is the appropriate investment size, given your risk appetite? What is the downside if you don’t invest?
Lesson 4: Dividends must be sustainable
One of the more interesting lessons from 2016 is that dividend sustainability became a key factor for company boards. One of the big catalysts to the rebound in BHP’s share price was the abandonment by the company of its crazy progressive dividend policy. It slashed its interim dividend by roughly 75% – from US62c to US16c a share. Other major miners followed suit.
ANZ cut its full year dividend from $1.81 in 2015 to $1.60 in 2016, the only major bank to do so. Interestingly, ANZ will deliver the best total shareholder return (price growth plus dividends) of any of the major banks in 2016. While there are other factors, a key takeout is that the market reacted favourably to the dividend cut.
Going forward, I think that the BHP and ANZ examples will lead other companies to determine that dividend sustainability is more important than any commitment to reward shareholders by paying higher or even steady dividends. Dividend and dividend payout ratios will fall.
Lesson 5: The commentators can (and will) get it wrong
Commodity prices? Brexit? Donald Trump?
How comprehensively wrong were the market experts and commentators (me included?). But not only did they get the outcome of the event wrong, they got the outcome on the market wrong. It was “universally” agreed that if Trump was elected, the US stock market would fall by 10%. Sure, it fell very briefly, but the rebound has been absolutely stunning. No one predicted this. The reaction to Brexit was similar, demonstrating that in cyclical bull markets (liker the US and Australian markets have been in post the GFC), gloom and doom events are buying opportunities.
Will these apply in 2017?
There is no doubt in my mind that the first three lessons of 2016 are “golden”, and will apply in 2017. So let’s repeat them:
- Diversification.
- Buy quality in the doom and gloom.
- Beware the high PE stock.
I think that the impact of the fourth lesson, dividends must be sustainable, will be noticed more and more in 2017. Dividend payout ratios are on the way down. This means lower dividends. It is not going to be dramatic, but the old days of company Boards just steadily increasing the dividend because “that’s what investors like” are on their way out. Income investors need to be cognizant of this.
Finally, can the commentators get it so wrong again in 2017? Possibly, only time will tell. One thing that is golden – when everyone agrees that a market/commodity/stock is going one way, it almost invariably goes the other way. The crowd usually gets its wrong.
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.