January 2017 Review & Comments
Written by Tony Gray   
Wednesday, 11 January 2017 14:30

Happy 2017,

This email sets out some thoughts on markets - as an alternative to the usual monthly portfolio covering letter. We are also trialing file sharing as a means of delivering reports and documents to you and welcome feedback on what does and does not work or meet your expectations. We are not automatically circulating an end of December 2016 portfolio summary - as by the time we complete the checks and reconciliation it will be almost time for the January portfolio record. We will of course generate a copy for you upon request and in most instances it is possible to log-in and check your portfolio at any time.

My comments below are focused primarily on Australian shares. Listed property is less expensive than it was a year ago, but is not yet generally at a safe buying point. Deposit rates are low and international shares are expensive at an index level, with the $A relatively low in the range - although diversification away from Australia is prudent.

Market Opinion

Looking at various investment manager opinions it seems most hold a positive outlook on Australian shares for 2017 - although not without the usual comments about running balanced portfolios and emphasising the importance of stock selection (as if this is never important). Opinions vary with completely different outlooks for sectors and stocks, even between well regarded managers with decent track records; which I guess just goes to show that no one gets it right all the time and why spreading exposure across a range of investments is sensible.

At the risk of opening a Pandora’s box of stock and investment questions - the following link to Livewire may be of interest to those who like to search for a variety of opinions (i.e. not just mine!) and can be pretty interesting, at least for those of us who actually enjoy reading financial ‘stuff’ -


My opinion - I think prices are too high generally for Australian and US stocks and there is a big difference between the performance of an economy and sharemarket performance. The US economy is strengthening but that market is very expensive - even accepting there are some high quality growth businesses (Amazon, Facebook, Alphabet - Google). The Australian economy is weak (that’s not a consensus view - but the economy contracted in the September quarter and today’s release of November retail sales showed growth of just 0.2% - important as consumption is responsible for around 60% of the Australian economy).

It would not surprise me if our market generates a positive return in the first half of the calendar year, fed by excess super contributions.  After 30 June 2017 the ability to make large super contributions to super is limited. When this situation arose in 1994 and 2007 we found a post 30 June hangover as money flows dried up and momentum reversed and my guess is we may see the cycle repeat.

The table below sets out Morningstar’s estimates for the S&P/ASX300 - the Actual represent FY2016 numbers and FY1 and FY2 are based on consensus estimates for the current 2017FY and 2018 FY respectively.

For me, a simple rule of thumb is that a market multiple of more than 20 times rarely results in a decent medium term return. After all, it means the market is priced at more than 20 years of current earnings - with no guarantee that earnings will rise over time (although history suggests this is the most likely outcome). In order to justify this market multiple, market profit growth would need to be well above average compared to the past few decades - and to me this seems unlikely.

The FY17 and FY18 growth numbers look quite healthy at 6.44% and 7.75% respectively but there are three cautionary notes; (1) Some of that growth is a recovery from sectors that suffered write-downs and large profit falls in FY16 - such as materials (mining), energy and consumer staples (in particular Woolworths); (2) analysts are an optimistic bunch and it is normal for growth expectations to be wound-back as time passes, and (3) demographics and economic drivers suggest weaker than average economic growth for some time in comparison to recent decades (slower economic growth due to higher taxation as a proportion of the economy, higher total economic debt levels, rising interest rates, slow wage growth, rising fuel costs…) - which has some bearing on profit growth potential.

Portfolio Approach

Diversifying across stocks reduces what can be termed ‘stock specific’ risk, where a major price fall particular to an individual holding (or multiple holdings in the same sector) might otherwise result in a decent fall in portfolio value.  We deal with stock specific risk through the setting of core and non-core allocations for portfolios. As a stock level we may hold a lower allocation to stocks that appear worthwhile on current earnings but carry too much balance sheet risk. A current example is the banking sector - decent value relative to earnings and yield, but with extremely high leverage. Holding some banking exposure is okay, holding too large an allocation introduces stock/sector specific risk.

What diversification will not do is remove ‘market risk’. If the broad market is falling then it’s a challenge - conversely, if the broad market is rising we want to make sure there is sufficient exposure in portfolios. This is where asset allocation decisions come into play - i.e. how much to hold or not hold in shares (or property, international shares, bonds for that matter).

So why hold any shares at this time? Well, chances are that my concerns are misplaced - or that I’m right about some of the risks, but just too early. Markets have a habit of climbing a wall of worry and despite major conflicts and recessions in the last century returns added up. There is also a risk of not being invested - especially with interest rates at such low levels that relying only on interest income results in an after-tax returns below inflation, or drawing capital to meet living costs.

We can still avoid sectors where risks are unduly high:

Example (1) - while listed infrastructure prices might be circa 20% lower than 2016 peaks, they (1) still appear expensive, and (2) are over-geared and hence rising bond yields could see further material price falls.  Given distributions are not franked and typically on the lower side we’re not brave enough to buy this correction. Where yields are higher, if you look under the bonnet it becomes apparent that distributions are part funded out of borrowings. It seems enough time has passed that shades of pre GFC behavior have re-emerged.

Example (2) Some high quality growth businesses are simply priced at too high a multiple of expected earnings - magnifying the degree of loss should something disrupt that growth profile (examples of fallen angels from 2016 include Bellamy’s, telco stocks such as Vocus and TPG and medical company Sirtex). Dominos Pizza is an example of a high priced growth stock - tremendous track record, but a little too much chilli for our taste. Of course company earnings may continue to rise strongly, although it is our judgement this is largely priced in.

Stock Recommendation

I intend this year to include a specific asset recommendation or comment with the monthly commentary. Don’t take the comments as a personal recommendation for your portfolio - that is something we need to discuss or consider in light of your position and approach - or you may already hold the asset in question or a similar asset. By all means email or make contact to discuss if you have some interest - otherwise we will consider as we review portfolios.

Future Generation Global Investment Company Ltd (FGG) - $1.06

Chaired by Geoff Wilson, this listed investment company provides diversified exposure to international shares and operates under an unusual arrangement. A selection of active global share managers forego investment management fees and instead a 1.0% annual donation is made by the company to charities that work to better the lives of young Australians affected by mental illness. The donation represents a lower cost than the base and performance fees foregone by the underlying boutique managers.

After initially trading at a substantial premium to asset backing (the float occurred in September 2015) the share price has settled down to trade at about asset backing (which is trending higher) and the payment of franked dividends has commenced. We consider this to be a worthwhile means of adding global share exposure to portfolios.

The attached link is to the monthly update on the FGG portfolio and the managers involved (examples include Magellan, Antipodes, Ellerston Capital and Paradice): http://www.futuregeninvest.com.au/Global/

A partner listed investment company - Future Generation Investment Company Ltd (FGX) provides an exposure to Australian shares using the same approach and is trading at around asset backing. Something we are keeping in mind if we see the need to add a broad market exposure.

Please treat the above comments as representing General Advice that has only considered the individual securities and not your personal position or goals and hence may not be appropriate.

Best wishes,

A.W. (Tony) Gray


TG Financial

Last Updated on Monday, 16 January 2017 08:20

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