There’s only one thing harder than spotting an exceptional company trading below its fair value: knowing when to sell it. Having the guts to dump a great company that has rewarded your portfolio many times over can challenge even hardened investors.
I’m talking about well-run companies with strong assets and consistently good performance. Companies whose biggest fault is being bid up too high, too fast, as investors arrive late at the party and fall for the hype. Companies you would be happy to buy again at lower prices.
I experienced this dilemma in June 2016 for The Switzer Super Report upon nominating three infrastructure-market darlings to sell before the financial year-end: Sydney Airport (SYD), Transurban Group (TCL) and Macquarie Atlas Road Group (MQA).
I had been bullish on these stocks, particularly Sydney Airport, for several years. Sydney Airport has fallen from $7.22 in June to $6.09; Transurban is down from about $12 to $10; and Macquarie Atlas Roads Group has drifted from $5.38 to $4.43.
Source: Yahoo!7
Source: Yahoo!7
Source: Yahoo!7
The infrastructure idea was probably a month early, but readers who followed it would have locked in gains near the peak of a multi-year bull run and avoided losses of 15-20% in a matter of months. As an aside, infrastructure stocks are starting to look more interesting after price falls.
Patience is needed. One can envisage infrastructure stocks falling further as interest-rate-sensitive stocks lose more favour. The market is betting on a stronger United States economy under US President-elect Donald Trump and higher US inflation and interest rates. Growth stocks, such as miners, are in demand.
This view is overdone. As I outlined last week for this report, a Trump Presidency presents as many threats as it does opportunities, such are the unknowns in his policy positions and whether he will – or can – tone down some of his controversial election promises.
The rally in resource stocks might go further in the next few months as more institutional capital rotates out of yield stocks into cyclical growth companies. Traders and active investors could ride the resource rally further. But long-term investors should buy or sell resource stocks based on their fundamentals, not second-guess market sentiment.
Hype about Trump’s effect on investment markets presents an opportunity to take profits on stocks that have soared, increase portfolio cash weightings and look to buy back at lower prices or capitalise on price weakness in infrastructure stocks, the banks and the Australian Real-Estate Investment Trusts.
My view is Congress will whittle down Trump’s trillion-dollar infrastructure plan because of United States deficit concerns, or delay aspects of the 10-year plan. Not enough ‘shovel-ready’ infrastructure spending will occur in the next two years to justify soaring gains in commodity prices this month.
Remember, China still accounts for about half of global base-metals consumption compared to the US at roughly 10%. Commodity bulls are due for a reality check.
As such, this week’s column continues the theme of selling soaring resource stocks. The ideas include Fortescue Metals Group, South32, Whitehaven Coal, and Sims Metal Management. The industrial, Treasury Wine Estates, is included on valuation grounds.
I emphasise that these ideas are based on valuations rather than company fundamentals. Treasury Wines, for example, has done a fantastic job selling wine in China. The Switzer Super Report included Treasury in its Takeover Portfolio in October 2015 at $6.50; it has since rallied to $10.60 after continually surpassing market expectations.
South32 is another example of a well-led company delivering stunning returns after earlier price weakness. The BHP Billiton spin-off joined the Switzer Super Report takeover portfolio in July 2015 at $1.78. The idea was too early: South32 hit 89 cents in February before soaring to $2.72 as commodity prices rallied.
Every stock has it price. The challenge is to put emotion to the side, focus on valuations and think about the portfolio implications of sell decisions (such as price entry points, tax issues and what to do with sale proceeds).
Talk to a good adviser before making significant portfolio adjustments or do further research of your own, if you are a self-directed investor.
Here are the five stocks to take some profits on, and why:
1. Sims Metal Management (SGM)
The global metals and electronics recycler has been a terrific turnaround story this year. Sims rallied from a 52-week low of $5.96 to $12.35 as the market bet on higher scrap-metal prices. The scrap price is highly correlated to the rising iron-ore price because scrap is a competing feedstock to iron-ore in steel production.
A rebound in scrap-metal prices in the fourth quarter of 2016 has boosted earnings and more than doubled the company’s valuation. As discussed in last week’s column, I doubt the sustainability of recent iron-ore price gains. Sims operates in an intensely competitive industry and has had a low return on equity.
Sims is doing a good job in cutting costs and deserves its rally this year. At $12.35, it trades on a forecast Price Earnings (PE) multiple of almost 30 times FY17 earnings based on some broker forecasts. That’s too high for a price-taking scrap-metal merchant.
Source: Yahoo!7
2. Whitehaven Coal (WHC)
Few observers predicted this year’s incredible rally in coal, a sector that looked on its knees 12 months ago. Thermal coal prices have jumped almost 80% since May and coking coal, used in steel-making, has more than tripled in price.
That, in turn, put a rocket under Whitehaven Coal and other leading producers. Whitehaven has soared from a 52-week low of 36 cents to $2.82, having peaked at $3.35.
The New South Wales producer delivered a record 20 million tonnes of coal in FY16; recorded its first full-year profit since 2012; reduced costs and strengthened its balance sheet. First delivery from its world-class Maules Creek Mine was another highlight.
Whitehaven is in good shape for 2017 and, clearly, doing lots of things well. But as I explained in last week’s column, Chinese steel output will moderate in the next six months and the Chinese government is moving to increase supply from coal mines there, to cap coal-price rises.
A price target of $2.80, based on a consensus of 13 analysts, suggests Whitehaven is fair value and only back to a level achieved in mid-2013. Much depends on one’s view of the coal price and the rally’s sustainability.
Taking some profits (or minimising losses for long-term holders) has merit given the uncertainty.
Source: Yahoo!7
3. Treasury Wine Estates (TWE)
The wine producer has defied the sceptics with a 43% total shareholder return (including dividends) over one year. Treasury’s leverage to the burgeoning Chinese wine market, and its strong management and governance, are attractions.
At $10.53, Treasury trades on a forecast PE multiple of 28 times FY17 earnings and 23 times FY18 earnings, consensus analyst estimates show. Those multiples leave no room for error in an intensely competitive Chinese wine market, where there is an array of product choice.
Treasury is well-placed, as the growing Chinese middle-class looks for premium wines and as it extracts further cost savings from its Diageo wine acquisition. But like all wine producers, Treasury faces weather risks, long production lead times and fickle consumers. The business does not have the type of competitive advantage that justifies such lofty valuation multiples.
Morningstar values Treasury at $6 a share. That seems a touch harsh, but there’s a good case for profit taking after Treasury’s rally.
Source: Yahoo!7
4. South32 (S32)
Few stock rallies have been more satisfying this year than South32’s. I wrote a piece on the diversified miner after it de-merged from BHP Billiton, suggesting it would fall (as is the trend with demergers, before rallying). South32 more than halved from its $2.13 listing price – much more than I expected – as the resource sector tanked.
Some commentators argued that BHP Billiton had bundled up its weak assets into South32 and dumped them on shareholders through an in-specie distribution.
I saw it differently: a company that came to market with a strong balance sheet, excellent board and management team, and a reasonable asset portfolio. South32 was irrationally sold at the peak of the resource rout, a reason why it made this report’s Takeover Target portfolio.
South32 is superbly positioned to acquire mining assets, given its balance sheet (though it probably should have snapped up assets earlier at lower prices) and is leveraged to the rally in manganese, coking coal and alumina prices. Its high cash generation should lead to a special dividend or other capital-management initiative in the next 18 months.
But median price target of $1.88, based on a consensus of 17 analysts, suggests South32 is overvalued at the current $2.72. A few brokers have price targets above $3, but they depend on commodity-price forecasts used in the valuation model being brought closer to spot prices.
Although a quality company, South32 still has mostly second-tier assets and plenty of its revenue relies on production in emerging countries with higher sovereign risk. Uncertainty about the current commodity-price rally adds to the risks, and is another reason to take at least some profits in South32 after soaring gains this year.
Source: Yahoo!7
5. Fortescue Metals Group (FMG)
I covered the iron-ore producer last week as part of a broader column about selling the market’s biggest miners.
The prospect of a Trump US Presidency overseeing an infrastructure boom has boosted iron-ore producers. But I doubt that change, if it happens, will meaningfully boost global iron-ore demand, given China still accounts for half of global steel production and has plenty of challenges to maintain its high growth rate.
The median price target for Fortescue, based on a consensus of 19 analysts, is $3.74. Even the high target of $5.61 is below the current $6.12.
True believers in a sustained iron-ore price rebound will continue to hold Fortescue and ride the rally higher. Those with a more sceptical view of global economic growth and resource-sector valuations could cash in on iron-ore euphoria by taking profits in Fortescue, with a view to buying back at lower prices when the reality of sluggish global economic growth resurfaces.
Source: Yahoo!7
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at November 22, 2016.
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.