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Published in Eureka Report on February 26
Build your own
wealth shelter
By Robert Gottliebsen
PORTFOLIO POINT: Here’s a strategy to hedge against each of the four risks to
your prosperity.
Last week I set out portfolio strategies from a leading adviser to America’s
wealthiest people. His advice to clients was to put a slab of their money into
safe liquid securities and another slab into a normal equity portfolio aligned to
a risk profile of the investment family. But he also suggested a third category:
investments to hedge against unexpected events (see Wealth insurance).
He didn’t elaborate but one of his risk hedge suggestions for American
investors is to invest in natural resources, which are rarely covered in
US equity portfolios. Of course, that would not be appropriate advice
for Australians, who normally have high levels of exposure to resource
companies in their portfolios.
This week I began by isolating four unexpected events that you might
need to hedge against: a serious downturn in China; inflation; the higher cost
of money; and oil prices. As I started studying these risks and stocks that
would protect you against these events, suddenly across my computer screen
came an email from Eureka Report contributor Roger Montgomery.
Roger writes the popular ValueLine column and we both have
participated in the Eureka Report series of DVDs. I have a great deal of
respect for him and his opinions. This is what his email said:
“I am very worried about the Chinese property bubble … I saw some
construction stats and it’s worse than I saw in Indonesia and Malaysia in
the 1990s prior to the Asian currency crisis; worse than I saw in Florida in
December 2007; and worse than Japan – 30 billion square feet now under
construction – that’s 23 square feet for every man, woman and child in
China.”
I immediately looked back at my first Eureka Report column for 2010, A
recession made in China? In this column I set out some of the European risks
that have dominated our headlines for the past six weeks before quoting an
alert raised by Par Mellstrom and Carl George of the Pivot Capital Group, the
same group that predicted the subprime crisis in the US.
You can read a summary of their analysis either on the Pivot website or
via my summary in that same column.
After talking to executives with experience in China, my initial fears
have been calmed. For example, BHP believes that while China will have
a slowdown but that the current banking curbs are a good move and will
prevent disasters from unfolding over the long term.
But the warning from Montgomery and the Mellstrom/George alert
suggest a severe setback in China is one of the risks that Australians must
prepare for. Unfortunately, it is the one we are all least prepared to handle.
Risk 1: Chinese downturn
If there was a serious setback in China then commodity prices, the Australian
dollar and Australian shares would go to the floor. Interest rates would rise
because our banks need overseas money and the Australian government
would have a serious funding problem.
So how do you pick a stock or stocks to cater for that situation? My
first inclination is to simply select safe stocks that have most of their assets
abroad. Westfield is a good example but it would not escape the global effects
of a Chinese downturn. Another traditional defensive group are retailers but a
lower Australian dollar would lift the cost of their stock and hurt sales.
The best stock I can come up with is CSL, whose health products are
relatively immune to economic fluctuations. CSL derives most of its revenue
from US dollars and euros. This was another stock that Roger Montgomery
identified as being undervalued back in November (see Healthy, wealthy and
overlooked) and has since gained about 10%.
It is true that the stock is priced for growth, which might be stunted
in tough times, but it represents a marvellous hedge against a Chinese
downturn and the subsequent fall in the Australian dollar. Cochlear and
ResMed would have similar attributes. In theory the miners are another good
pick but in practice a lower Australian dollar is likely to be linked to a fall in
metal prices.
Risk 2: Higher costs of capital
When it comes to the higher cost of money it poses serious questions for
the entire market. Two weeks ago I set out the BHP Billiton strategy which is
preparing the company for rises in the cost of money on the back of much
higher government borrowing, both in the US and Europe (see BHP’s brilliant
strategy). There are also new banking capital regulations that will affect the
cost of money.
BHP is the first to concede that it could be wrong, and if that happens
there is an alternative strategy to buy back the British arm of the dual-listed
organisation. But there is no thought of that move or any capital return move
when there is a possibility of a significant rise in the cost of capital.
BHP wants to be in top shape to buy depressed assets if they come on
to the market so in theory holding BHP would give you a long-term benefit
from a rise in the cost of capital. But there will also be a lot of short-term pain
because almost certainly commodity prices will fall with higher capital costs.
Your best hedge against a sharp rise in the cost of capital is to buy big
Australian bank hybrids. They obviously carry a risk, which makes them
vulnerable if an Australian bank were to get into trouble. But that is not likely:
the interest rates on bank hybrids will rise with market rates. The table below
lists Australian bank hybrids. I would not stray from our top banks when
investing in hybrids.
Australian bank hybrids
Code
Name
ANZPA
ANZ Converible Preference Share (CPS)
ANZPB
ANZ Convertible Preserence Share 2 (CPS2)
CBAPA
CBA Perpetual Exchangeable Ressettable Listed
Securities (PERLS V)
CBAPB
CBA Perpetual Exchangeable Ressettable Listed
Securities (PERLS IV)
WBCPA
Westpac Stapled Preference Security (SPS)
WBCPB
Westpac Stapled Preference Security (SPS2)
Risk 3: Inflation
The stocks that will protect your portfolio against inflation the best are
Transurban and ConnectEast. I wrote about Transurban in November (see Why
I like Transurban). The risk with this stock is that right now it is a takeover
target and may not be listed here forever if the Canadian pension funds
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pursue their $5.25 a share bid.
Transurban’s revenue is linked to inflation, and toll roads are a traditional
defensive stock that will not be greatly affected by a normal downturn. The
Canadians correctly concluded that Transurban was one of the best inflation
hedges in the world.
Takeover specialist Tom Elliott has alerted Eureka Report readers that if
the Canadians disappear Transurban shares will fall. There is no doubt that
is true, but conversely over time they will rise much further as the true value
of their assets is recognised. If inflation breaks out they will rise strongly and
your portfolio will, too.
In the latest half-year Transurban performed particularly well.
ConnectEast operates a toll road on the east of Melbourne, and is, if you like,
a poor man’s Transurban. Its revenue is also protected against inflation but
its single toll road doesn’t have the same maturity of Transurban’s assets.
Nevertheless, the combination of the two investments represents one of the
best inflation hedges in the country.
However both companies have borrowings, which are manageable in
the short term but if there is a rise in the cost of capital it will reduce their
performance but not destroy their prospects. As I wrote last year, my family
has investments in both Transurban and ConnectEast for the reasons I have
outlined. I can’t get that hedge anywhere else so I am not interested in selling
to the Canadians.
Risk 4: Rising oil prices
My final event worth considering protecting against is a rise in the price of
oil. Now of course if there is a problem in China or a rise in the cost of capital
one would normally expect oil to fall in price. But oil has its own dynamic and
it is clear that we are not generating the reserves of oil necessary to match
the increasing demand, and traders are beginning to appreciate this growing
shortage. So all other things being equal, investors should include the price of
oil among the big risks to their wealth.
BHP Billiton has good oil assets but the uptick in its Petroleum division
would be diluted from its other business earnings. For pure oil exposure,
Australians would need to invest overseas.
The best the local market can provide is a mixture of oil and gas
exposure, and here Woodside and Santos are the two best stocks for you.
Woodside’s long association with the North-West Shelf and a number of new
projects make it an obvious choice. Santos also has a good variety of projects
but its secret weapon is its exposure to emerging and exciting export gas
developments on the eastern seaboard.
I would not suggest that the protections that I have suggested against
the four risks are an exhaustive risk of investments, but they are a good
start. I welcome suggestions from readers because an article like this should
be both informative and a thought-starter. If you have any suggestions then
please click here. u