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May, 2017 8:58 AM



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Is It Time to Get Defensive?

Is It Time to Get Defensive?

By Bob Kohut 15.05.2017


Prior to the release of the 2017-2018 Federal Budget an article in The Australian proclaimed Budget 2017: businesses booming and expecting the good times to roll.

Research from two of the Big Four Banks support the conclusion.

The International Monetary Fund (IMF) chimed in with a pre-budget announcement on the growth of the Australian Economy including forecasts exceeding those of our own Treasury Department.  The IMF forecasts economic growth in Australia at 3.1% in 2017 and 3% in 2018.

The overall tone of the actual 2017-2018 Federal Budget was positive, predicting a return to a budget surplus by the end of the decade.  For contrarians, the budget assumptions of a 14.7% increase in corporate tax receipts based on the recent surge in the prices of iron ore and coking coal give pause.

Our positive economic outlook suggests ASX stocks will benefit from an equally optimistic world view.  US markets set the pace for global markets everywhere and the US has been in rally mode since the election of maverick Donald Trump as US President.

Investors there are salivating at the prospect of a surge in US economic growth propelled by the pro-business agenda of the Trump administration.  Changes in the regulatory environment coupled with drastic reductions in the corporate tax rate from the current 35% to a proposed 15% are fueling investor and business optimism.  In the US, the best gauge of investor fear is the Chicago Board of Exchange (CBOE) Volatility Index which is at its lowest level since the closing days of calendar year 2006.

The latest Quarterly World Economic Outlook from the IMF raised its projections for global economic growth to 3.5%, up from January’s forecast for 3.4% growth.

Given this optimism why would anyone other than the most permanent of Perma-Bears consider going defensive in this environment?

The case for that contrarian viewpoint centers on two countries – the US and China.

In the US, the chairman of investment bank Goldman Sachs recently stated the extremely low levels of the VIX (Volatility Index) “may be a bit of a bubble of confidence, but we won't know until we know."

Despite holding the Executive Branch of the US Government and majority power in both houses of the legislative branch, the Trump agenda has stalled amidst swirling uncertainty about just about everything going on there. The Tax Plan remains in the minds of Trump and some of his advisers with no formal drafting for legislative debate.  Another proposal whetting the appetites of investors is Trump’s plan for $1 Trillion dollars in infrastructure spending, also lacking in specifics and currently in limbo.

Some veteran Aussie investors view tales of economic disasters looming in China like a broken track on a record. Despite multiple siren calls of impending doom over the past decade, somehow or other the Chinese government manages to pull a proverbial rabbit out of their hats. 

That may happen again but some investors are taking notice of the recent bearish view from respected Bank of America/Merrill Lynch analysts.  An article in the Sydney Morning Herald, with the provocative title: Forget the Trump trade, China's the real driver of equity performance: BAML, made the following observation drawn from the BAML note to its investors:

…global investors should adopt a defensive stance, as growth in China, which accounts for nearly a fifth of the world's GDP, has passed its peak.

In the first week of May China reported lower than expected results in both trade data and the Purchasing Manufacturing Index (PMI) – an economic indicator gauging the health of a country’s manufacturing sector. The Chinese official economic growth forecast for 2017 is 6.5%, the lowest growth rate in more than twenty years.

The top economic strategist for Charles Schwab has concerns private sector spending in China will not pick up the slack from the government slowdown on infrastructure spending, as the government hoped.

The Australian case of going defensive stems from the budget’s reliance on revenues from exports of iron ore and coal.  These commodities got off to a red-hot start at the beginning of the year but have fallen off the cliff of late, as the following price charts for both indicates. 

Some cynical investors might scoff at the notion of “getting defensive, recalling numerous after the fact observations from market experts that there were no defensive stocks withstanding the crushing impact of the GFC.

Stocks in sectors traditionally considered defensive, most notably utilities and healthcare, are often the favorite hiding places in tough times, and virtually no one is even hinting at an impending Round 2 of the GFC.  Utilities might seem the best bet, as people can delay certain healthcare treatments but not many consumers or corporations can turn off the lights or the heat.  

Here is how the ASX Utility Index and two of the top utility stocks on the ASX – AGL Energy (AGL) and APA Group (APA) fared since 2007, about a year before investors felt the full fury of the GFC.

The Healthcare Index fared better, and two of the top healthcare stocks on the ASX emerged from the GFC virtually unscathed – Ramsay Healthcare (RHC) and CSL Limited (CSL).  

Ramsay hospital beds and CSL blood plasma treatments and vaccines are not the kind of healthcare services one can do without in tough times.  For the long term both these stocks are going to benefit from the swelling population of seniors from the baby boom generation.

Another stock from a different sector that provides essential services in challenging times is funeral services provider InvoCare Limited (IVC).  This company also stands to benefit from all those baby boomers who despite living longer lives will eventually be in need of the services InvoCare provides.

The company’s stock price performance exemplifies the attraction of defensive stocks.  The following price movement chart shows the IVC share price in decline going into the GFC and rebounding almost immediately.

On 24 October as the GFC was clearing its throat for the roar to follow IVC was trading at $4.49 and it has been going up ever since.  The stock price, like the price of both RHC and CSL, has seen some dips along the way but the historical performance of all three has been stellar.

Some market experts remind investors “looking in the rear-view mirror” is not the thing to do when investing in a stock.  However, successful extreme value investors set rigid five and even ten-year performance standards before considering a stock.  Certainly, past performance is no guarantee of future performance.  But it is an indication of the ability to withstand the ups and downs of economic cycles over long periods.  The key is looking to the future to assess changing conditions that might affect performance.

The following table looks at the historical performance of these three defensive plays.

Some investors prefer to invest in stocks that one might call glamorous.  Who wouldn’t be proud to brag to friends and associates about a stake in a biotech stock working on a cure for a dreaded disease.  There is nothing glamorous about death and stock ownership in the funeral industry does not make for scintillating cocktail party chatter.

However, InvoCare controls more than 30% of the Australian and New Zealand markets and is expanding in Singapore and entered the US market in 2015.  The company owns and operates branded funeral homes along with cemeteries and crematoria.    The US business failed to meet expectations and the company announced closing of the traditional funeral operation in Southern California while keeping the crematoria open.

Full Year Results presented in February showed revenues with a modest increase of 3.3%, but net profit after tax (NPAT) rose a healthy 29.4%.  The company’s business models features funeral services to meet a range of incomes.  

InvoCare’s revenue and profit growth has been modest in comparison to Ramsay and CSL but the demand for its services is unquestionable.  US founding father Benjamin Franklin reportedly once said “in this world nothing can be said to be certain, except death and taxes.”

At points along the path of success enjoyed by Ramsay Healthcare and CSL, market experts have from time to time cried out the lofty Price to Earnings Ratio for both makes them “expensive” stocks, yet they continue to grow and reward their investors.  The following chart looks at the year over year price performance of all three companies along with two-year growth forecasts for earnings and dividends.

CSL Limited may have the highest P/E, but it also has the highest growth forecasts.  On 25 January, the company raised its profit forecast for 2017 from an 11% increase over 2016 to a range of 15% to 20%. CSL has room for growth as evidenced by its pipeline of new treatments under development.   The company has a strong Research & Development operation, including partnerships with leading academic and research institutions. In December of 2016 the company held an Investor Presentation to highlight its more than 30 new offerings in its pipeline, with more than half in late-stage clinical trials.

Ramsay Health Care has grown from its inception in 1964 to become one of the top five hospital operators on the planet.  Ramsay operates more than 220 hospitals and day surgeries stretching from Australia to Indonesia to Malaysia to France and the UK and is entering the pharmacy business.

The International diversification cushions the company from regulatory issues or downturns in one country. Ramsay has room to grow and despite having paid a dividend every year since 2000 maintains a payout ratio around 50% to preserve capital for expansions.  The company is already expanding its bed count to be ready for the demand uptick from the Baby Boomers.  

In March of 2016 Ramsay withdrew from a Joint Venture operation with Chinese healthcare group Chengdu Jinxin Healthcare Investment.  In 2015, Ramsay had announced a Chines government supported Joint Venture with Jinan University No.1 Affiliated Hospital also known as Guangzhou Overseas Chinese Hospital, to open four hospitals in the heavily populated Pearl River Delta Region.

The company’s Half Year 2017 results released in February reported a 3.5% revenue increase along with a 12.8% rise in NPAT.  Management provided a growth strategy update with plans for adding facilities and expanding the company’s latest venture –Ramsay Pharmacies. There are 22 pharmacies currently in operation with management pledging to “rapidly expand the network in 207 and beyond.”   There was no mention of the status of the remaining Chinese Joint Venture, but given the company’s efforts to begin operating there, it seems likely Ramsay Healthcare will eventually plant its footprint in the Chinese market.


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