Fishing for GARP – US dollar stars

Chief Investment Officer and founder of Aitken Investment Management
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In writing investment strategy each week, I have to remind myself to be bold and make “forecasts”, not “back casts” or “present casts”.

The “present” is extremely efficiently priced in, due to high frequency trading, advances in telecommunications, real time information to investors and financial TV networks that call markets like sports broadcasts. However, the future is highly inefficiently priced and the “time arbitrage” in markets remains large and exploitable.

The future is not now

Quite interestingly over the last few months as I have banged the “be cautious in yield equities in Aussie dollars” drum, I have had numerous responses about “interest rates still being very low” and yield equities currently looking attractive versus cash. That is absolutely right today, as it was a month ago, but what I am trying to do is forecast what the screens in front of us say in six to 12 months’ time.

To put this in context, Australian cash rates were unchanged at 2.50% over the last month, but what happened was that changing US interest rate expectations drove Australian bond yields up 45 basis points to 3.73%, the Australian dollar down 6 US cents (-6.4%) and the Australian financial sector down -7.5%. With local cash rates unchanged, due to carry trade unwinding, you lost in capital terms your annual grossed up dividend yield in Australian financials and you can double that capital loss in US dollars terms. This should remind everyone we are part of global markets and a myopic home bias can be costly when global macro trends change.

I have to look forward, position forward, and hope that 75% of my predictions are right and the 25% of predictions that are wrong are just flesh wounds to the overall forward looking strategy.

To me it’s sort of like fishing. You set the bait, then wait for the tide and fish to come to you. In this case, I am fishing for Garp.

What I am going to do today is to look for potential beneficiaries of the rotation from yield equities that has started. As yield equities start to relatively underperform and become lower weightings in benchmark indices, what will investors rotate to and see an increase in their index weighting, remembering the overall power of the index fund, quasi index fund and ETF industry.

Growth at a reasonable price

I simply think the capital beneficiaries of rotation with be growth at a reasonable price stocks. I think investors will de-weight “dividend yield” as a variable in the investment case, and up-weight “EPS growth”. I also think dividend growth, driven by earnings growth, will outperform basic dividend yield. In my strategy, all roads lead to GARP stocks and the best performing GARP stocks will have a high proportion of US dollar earnings.

The first problem in large cap Australian equities when you are “fishing for Garp” is actually finding some decent double digit FY15 EPS growth. ASX200 EPS growth is only forecast to be 5% in FY15.

I approach this via running quant ranking screens across the ASX50 Leaders Index (XFL). The rankings are based off current consensus FY15 EPS and P/E forecasts from Bloomberg. That takes out any potential earnings biases in our own company forecasting.

The table below ranks the least attractive then the most attractive ASX50 leaders industrials in terms of FY15 price to growth ratio (PEG) (Price Earnings Ratio divided by Annual EPS growth).

Let’s start with the least attractive on PEG ratios

Now the most attractive on PEG ratios

Obviously, this is NOT a perfect science and based off the current consensus FY15 forecasts, which history suggests are usually somewhat wrong. However, these tables do give you a guide to where GARP is, and GARP isn’t. That is the purpose of the exercise.

Unsurprisingly, the “least” attractive table is dominated by high yield names. That makes perfect sense as people have bought those names for income and those boards have generally increased payout ratios to feed those investors what they seek. If you buy yield, you are usually sacrificing growth. Yet, this exercise does remind you how “growthless” those stocks are.

US dollar stars

The “most” attractive list is dominated by lower dividend yield, high proportion of US dollar earners. NAB and Macquarie are the only large cap banks to make the list, again mainly due to offshore earnings streams.

In my mind, these lists are a correct interpretation of where GARP is and isn’t in the top 50. I suspect this list is telling the SMSF world that if you want to maintain dividend yield exposure but simultaneously increase growth (and US dollar) exposure, then you should be switching in financials from CBA and Westpac to a combination of QBE, Macquarie and NAB. Doesn’t that idea make your squirm? Which means it will probably be right.

My final point is the current combined ASX200 Index weight of the “least” attractive PEG names is 29.5% while the current combined ASX200 index weight of the “most” attractive PEG names is just 13.7%. This again reminds me how hard it will be for the benchmark ASX200 index to move forward significantly with such a high weighting of yield stocks and low weighting of growth stocks in a rising bond yield environment.

I continue to position model portfolios for growth to outperform yield and US dollar earners to outperform Australian dollar earners.

I am also positioning model portfolios for an increase in volatility and increase in stock price divergence.

Cash is held in US dollars.

Don’t fight the Fed. Don’t fight the tape.

100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.

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.

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