I highly doubt many of you thought Donald Trump becoming president of the United States would be a boon for your equity portfolio. However, here we are and the Trump tax cutting and growth spending narrative has been completely bought into by equity markets. On the other hand, bond markets have been smashed. Over the last few years, equity and bond markets have moved in tandem, to me this new divergence is a concerning development.
Christmas has come early for equity investors and I think it’s time to take some trading profits in cyclical equities. My view is investors should be locking in some of the windfall gains they have experienced in the last few weeks. In my view, these prices won’t be sustained as the reality of Trump lags way behind the lofty expectations we see priced in today.
I simply believe markets have gotten way ahead of themselves on so called “Trumpflation”. The ASX200 had its best November in 11 years. Where prices have been pushed to almost ensures disappointment in the weeks and months ahead. You’re basically buying “hope”, but “hope” isn’t an investment strategy.
For example, US heavy construction material stocks are up between +30% and 40% since the election. P/Es have risen from 14 to 18x. This is all on expectation of a huge infrastructure upgrade program.
However, this will prove many years premature. The Wall Street Journal ran an excellent article titled Numbers don’t add up for Trumps trillion-dollar building plan. They are correct: the key problem is, how do you pay for it?
Nobody argues America is in need of critical transport infrastructure upgrades, but Trump’s plan of public private partnerships is flawed. For example, of the 14 completed highway projects that relied on some form of private financing in recent years, eight have either declared bankruptcy, or experienced a public buyout of their private partners. All relied on toll revenue and quite simply, Americans don’t like paying tolls. They expect their taxpayer dollars to pay for highways.
While private-public partnerships seem like an easy way to build infrastructure without borrowing too, history shows such plans are much harder than they appear.
My view is Trump will turn out to be “hopeless”. The likelihood of Trump delivering on all his promises is zero. He is going to find it much harder to deliver than his supporters or the markets currently think or price. This is a classic moment in markets and my advice is to lock in some of the windfall gains you have experienced in cyclicals in the last few weeks and move to the sidelines. Holding some cash may not be a bad thing as the return on cash is rising and its capital risk free.
My advice is to take some profits before Trump’s inauguration on January 20th. In fact, I’d be taking some profits right now, as two months is a long time in markets and we are only one ridiculous “tweet” away from a genuine pullback in expectations, and therefore prices.
Why am I such a sceptic on what Trump can deliver? Because I simply believe he lacks the ability to deliver due to a lack of funding for his ideas. At the same time, the Federal Reserve will be raising interest rates and the world is charging the USA a higher rate of interest on any new borrowings or amounts that it eventually rolls over.
US 10-year bond yields have risen from 1.83% to 2.38% since Trump was elected. That’s a 7.5% capital loss for US bond holders, and the world thinks about the higher risk of the US defaulting on its debt under Trump. That, in turn, has led to US variable mortgage rates rising by around .4%, a roughly 10% increase in monthly mortgage payments for US mortgage holders. Yes, Mr. Blue Collar with a variable rate 30-year mortgage is already significantly worse off under Trump. This is an important point. Make America Great Again, hey? An interesting start to that, with Middle America’s mortgage belt already significantly worse off since the Presidential election. Gasoline prices have also risen sharply, which is a regressive tax on the middle class.
While Middle America is worse off already under Trump, ironically, Wall St has been the winner. US investment banks, such as Goldman Sachs, Morgan Stanley and Bank of America Merrill Lynch have led US equity indices to all-time highs. In fact, gains in financial stocks have accounted for over 50% of the index rally since the election. Make Goldman Sachs Great Again. Did those who voted for Trump really think they were voting for Goldman Sachs’ share price to do this? +23% this month … and one of their alumni will be Treasury Secretary.
So, already, Wall St is “Trumping” Main St.
That wasn’t how this was meant to play out, and to me, this is just the start of an extended period of volatility where all of us are going to increase the amount of trading we do in our portfolios to deliver superior returns. These WILL NOT BE BUY AND HOLD EVERYTHING MARKETS. Far from it – we are going to see big swings in sentiment and big tradeable swings in sentiment.
You’ve already seen a classic example of a major sentiment swing in the last month. US equity futures curbs kicked in at -5% on the day of the election. Yes, US futures were “limit down”, only to recover to record highs within two weeks. Again, this is sentiment, not economic fact, and it is reasonable to expect further large sentiment shifts in the weeks and months ahead. That is why I believe it is time to take some trading profits in cyclicals and raise cash levels.
If you do take some profits in cyclicals that have run ahead of themselves, what do you switch to? Well, my answer is structural growth stocks that aren’t reliable on government spending or central bank policy.
Aristocrat (ALL)
I wrote to you last week about Aristocrat (ALL), previewing what I thought would be an excellent result. The good news is ALL delivered an even better result than I expected and absolutely cemented itself as the world’s no.1 manufacturer of gaming machine hardware and software. This was a truly great set of numbers and I remain a high-conviction buyer of ALL shares, which were actually left out of last month’s rally which favoured cyclicals. ALL is down about -10% from all-time highs, and I see that as a great buying opportunity for exposure to the structural earnings, cash flow and dividend growth it offers.
To summarise, the research on ALL from the no.1 rated sector analyst at Citi:
FY16 NPATA of $398.2m (+69% YoY) was above Citi (c$391m), consensus (c$382m) and guidance (c$366m) despite higher-than-expected cost items, with D&D and corporate costs coming in c$20m above our estimates in aggregate, and net interest and tax also above our expectations.
Segment profit (+45% YoY) was 4% above Citi, largely due to beats from North America and Digital, with Digital margins again surprising on the up in 2H (42% constant currency vs. Citi c38.5%). 2H North America participation net installs of 2,062 units was well above Citi (1,600) and 1H (1,805) and was the key driver of the Nth Am beat. We, however, assume c21% growth in ALL’s net install base and c4% YoY growth in yields in FY17e, which we view as a key earnings driver in FY17e.
Our FY17-19e EPS has increased marginally (by c1-2%) and our revised FY17e NPATA of c$478m (from c$469m) implies c20% YoY growth and is c10% above pre-result consensus.
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As you all know, I value companies on the cash they generate. On that basis, ALL’s cash conversion of 160% is outstanding and led to a major reduction in net debt.
Currently trading on a c20x/18x FY17-18e PE, in line with market (All Ind 200 ex Fin) and below its historical 1 yr forward PE of c20x, we view ALL’s current pricing as attractive given its growth outlook (c16% two yr EPS CAGR to FY18e), strong market positions, cash generation (free cash flow yield of c6% in FY17e) and balance sheet (FY17e ND / EBITDA of <1x).
I genuinely believe this will be a $20 stock over the next few years. On a FY17 PEG ration of 1x, ALL is cheap.
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.
