There’s certainly no lack of volatility this month as bond yields rise globally and the British Pound starts facing the reality of Brexit.
US 10-year bond yields (USGG10): breaking the downtrend from earlier this year
British Pound vs. US dollar (GBPUSD): harsh reality of Brexit dawning
The US dollar has risen sharply as expectations of a Federal Reserve rate rise increase. Market are now pricing in a 70% chance of the Fed raising rates at its December meeting, and this combined with the free-fall of the Pound has seen the US dollar Index (DXY) break higher.
US dollar Index (DXY); breaking the downtrend from earlier this year as US interest rate rise expectations increase
Of course, major moves in bond yields and currencies cause cross-asset class volatility and rotation between sectors in equity markets. As bond yields and the US dollar have risen, we have seen rotation from defensives, yield and gold to banks and other cyclical sectors. Net equity markets have hung in well, albeit with higher volatility, as most investors realise the far greater downside in terms of capital is in long bonds rather than equities. If anything it appears some money is moving from bonds to equities amongst all this. That is good news.
As you are well aware, I am very concerned about bond markets.
At AIM, we are prepared and positioned for volatility around the US Presidential election and the likely Fed interest rate rise in December. There will also be stock-specific volatility generated by the US equity reporting season.
Our biggest concern remains the bond market and bond like equities. We believe long bonds remain “return free capital risk” and the fund has physical short positions in US 30YR Treasuries that will generate us positive capital gains if we are right and long bond yields start rising globally.
We are also short specific bond like equities, feeling there are many “bond tourists” hiding in them, with the vast bulk of those shorts being in Real Estate Investment Trusts (REITS). We believe REITS have peaked in price globally and premiums to NTA will start to narrow (share prices fall). The “ringing the bell” moment in the REIT sector was recently when the REIT sector itself was spun out of the Financials sector in the US. REIT’s are now the 11th major US sector and these sort of things ALWAYS happen at the top of a bubble.
In bonds and bond like equities the capital loss potential far outweighs the short-term yield you are receiving. If bond yields start to rise as inflation creeps up (our view), then long bond yields will rise sharply and bond like equities will act as leveraged derivatives of those rising long bond yields. The capital losses could be very substantial and that is why we are prepared to short the yield in expectation of capital gains well exceeding the yield we pay away.
The biggest risk to all risk asset classes remains and unexpected rise in inflation. It’s worth remembering most central banks are “inflation targeting”. No doubt bonds and bond like equities offer the greatest capital downside leverage to a rise in inflation. Our view is inflation readings globally have bottomed and now cycle tougher pcp comparisons. The easy benign inflation yards of falling commodity prices, particularly oil, now seem behind us (OPEC’s first production cut in eight years). Similarly, full employment in the US is showing the first signs of wage inflation. Yet, here we are and a US 30yr Treasury is discounting no inflation for the next 30 years.
The final bear point on long bonds is whether governments move away from unpopular ‘austerity’ to ‘fiscal spending’. This appears to be in the infancy of happening and will lead to further issuance (supply) of long bonds at a time when demand could be fading. You can understand why we are short US 30yr Treasuries. We believe the risk/reward equation is now heavily in favour of reward for those prepared to short the blatant bond market bubble.
While rising bond yields will be bad news for bonds, bond like equities and highly geared companies, as always we remind ourselves “it’s a market of stocks, not a stock market”. As bond yields rise, so too will cross asset class volatility, but in that volatility will be opportunities to add to what we believe are “structural growth” equities.
The AIM Global High Conviction Fund is long “structural growth equities” in the USA, China, the UK, NZ and Australia. The vast bulk of our long investments have tremendous balance sheets, generate substantial free cash flow, possess a sustainable business advantage and generate high, sustainable ROEs. They also trade on price to earnings growth ratios (PEG ratio’s) generally less than 1x. Interestingly, the median dividend yield of our long portfolio is around 2.5%pa. We are clearly invested in growth over yield.
So today, let’s reaffirm our positive view on what we consider an Australian structural growth stock, Aristocrat Leisure (ALL).
ALL has been a great performer for our fund but we are of the view there is much more to come. We believe this is an ASX listed global leader in its industry that will command a premium to its peers and a premium to the ASX200.
ALL has every attribute we seek in an investment, but most notably strong sales growth and market share gains.
The 2016 Global Gaming Expo (G2E) was recently held in Las Vegas. The event saw ALL display another strong and diverse line up of outright sales and participation product innovations.
To put this in context, G2E is the major gaming conference of the year and it’s very important for generating new orders and sales for the year ahead. Our feedback from a variety of sources was that ALL’s stand was “constantly packed” and there was great interest in new licensed titles on display, including Tim McGraw, The X Files, The Big Lebowski, Sharknado and My Cousin Vinny. The highly anticipated Dragon Link of proprietary games was also on display. There was no shortage of new and exciting software from ALL.
On the hardware side new cabinets Helix +, Flame, Edge and VGT content on the new Ovation cabinet.
While most readers would probably say “so what” to the above, in gaming technology, new and exciting product is everything. These are highly competitive markets and product innovations that can attract greater player time clearly increase the return to the casino owner.
Quite simply, if your product is increasing the return to the casino, they want more of it. It’s that simple and that is what is driving ALL’s top line and bottom line growth.
It appears every analyst who visited G2E came back and UPGRADED their ALL forecasts. Citi, for example, now has forecasts 6-8% above the most recent guidance from ALL, based on high assumptions of “Class III” stepper shipments.
Let’s have a look at a financial forecast for ALL for the next three years.
Note that while dividend yield is low, dividend growth is strong. This is exactly how structural growth stocks work. You are in ALL for earnings growth and dividend growth.
On a PEG ratio of 1x, what we believe will prove conservative 2017 EPS forecasts, ALL is inexpensive vs its growth and free cash generation.
In summary, ALL has entered a new product cycle led by a broadening game portfolio in North America. We believe the company is in the middle stages of a market share growth story, particularly given the structural growth of its installed base of participation games.
Market share gains are also being supported by a favourable competitive environment with three of ALL’s major competitors distracted with M&As.
The acquisition of VGT, a leading Class II game supplier, as well as its entry into social gaming further adds to ALL’s attractive medium-term growth profile.
If our forecasts prove right and ALL delivers on its growth, then we believe ALL will break into a higher trading range between $18.00 – $20.00. We see ALL as a core portfolio holding and recently increased our holding to around $16.00.
The house always wins, but it wins more with ALL product.
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.
