Four big lessons from 2017
As the dust settles on a tumultuous 2017, here are four lessons that James Dunn has taken away from the year.
1) Political – and geo-political – headlines don’t drive investment outcomes
Investors already knew from the US election in November 2016 that the political and market reactions to the Trump victory were inconsistent, to say the least. As it became clear on election night that Donald Trump had won the White House, the futures market versions of the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite indices each fell 4.5%–4.6%, almost going “limit down” – that is, reaching the maximum allowable fall on the futures exchange. Nobel Prize-winning US economist Paul Krugman told a TV interviewer that markets would “never recover” from Trump’s election. Shocked pundits predicted a collapse when the actual market opened on that November Wednesday morning. As it happened, the US markets surged the next day – and have mostly kept rising through the Trump Presidency so far.
It is not that the US markets love Trump and his policies – although markets did appear to welcome proposals for lower taxes and massive infrastructure spending, which they saw as positive for economic growth. The 2017 rise is based more on the fact that irrespective of politics, the US economy is growing at its strongest rate in three years, corporate profits are booming, businesses are spending, leading indicators of manufacturing are on the rise, jobs creation is surging and unemployment is the lowest it has been in 17 years.
Politically, there is increasing polarisation in the US, the President is facing bitter opposition from the Democrats and rebellion from many legislators ostensibly on the same side, and the liberal-dominated US media is bitterly opposed to him, if not actively campaigning for his impeachment. Anyone focusing on the political headlines could be forgiven for believing that Washington, DC, is a toxic swamp of vitriol. But the business world and the stock market focus on other things – and in that world, optimism abounds, particularly on the back of synchronised global economic growth, the first time in almost ten years that situation has applied. Thus, you have the US markets riding high in 2017 to date: the Dow Jones Industrial Average up 21.9%, the S&P 500 Index up 16.4% and the technology-heavy Nasdaq Composite Index almost 24% to the good.
Undoubtedly there are plenty of investors who do not like Donald Trump, and for whom the lurid stream of headlines is confirmation that they are correct to dislike him, and that he is a disastrous President. But if you’re one of those investors, you have to accept that the economic situation is vastly different to the political.
It is a similar story on the global arena, where the seemingly perennial conflict in the Middle East, the alarming procession of apparently ever-more-powerful North Korean nuclear missile tests, and all of the constant backdrop of the Brexit negotiations, Spanish and German political crises and the ongoing threat of terrorism conspire to make the world sound like a very troubled place. But the stock markets, which focus in the long run on the economic setting and the prospects for company earnings, largely screen-out that backdrop as noise.
For example, while the rogue North Korean regime continues to test-fire its missiles out over Japan, the South Korean KOSPI Index and its Nikkei counterpart in Japan have added 17% and 22% respectively this year. Of course, if the heightened tension on the Korean peninsula were to result in actual shooting, the stock markets would take a significant hit, because of the economic and trade disruption that would follow – but in the meantime, the markets are not fazed by the headlines. Nor should investors with a long-term horizon allow themselves to panic.
2) Australian investors need overseas exposure more than ever
Like their counterparts worldwide, Australian investors have a strong bias toward their home stock market: familiarity with the companies is a big driver of this, as is unwillingness to take currency risk, and this bias is magnified by the dividend imputation system, in which franking credits can add another 0.5%–1% a year to investors’ returns. In particular, the huge demand from Australia’s growing ranks of self-managed superannuation funds (SMSFs) for franked dividend income – which is extremely tax-effective in their hands – drives heavy preference for local stocks. But Australian investors face some big drawbacks stemming from home bias.
Chief among these is that the local share market is one of the most concentrated in the world. The top ten companies represent nearly 50% of the capitalisation of the market benchmark, the S&P/ASX 200 index. The top four companies are the ‘big four” banks: financials make up about 40% of the index. Add the large resources and real estate companies to that and you have the S&P/ASX 200 index driven by the performance of a small number of large listed companies, in a small number of industries.
This imbalance remains the major reason why Australian investors need to invest overseas: to improve the diversification of their share portfolio, by giving them greater exposure to the global economy and to industries that their home market simply does not have. In the US, European and Asian stock markets, Australian investors can tap into long-term growth opportunities in a range of industries and sectors that are not accessible in a purely domestic share portfolio.
This fundamental justification for international diversification is only heightened by the current global market upturn, which is arguably being driven by factors not shared by Australia. In particular, the US markets are being driven by the big technology stocks: the FAANG Group, short for Facebook, Apple, Amazon, Netflix, and Alphabet’s Google. Microsoft should also be included in the main drivers of the market: so far this year, the FAANG stocks plus Microsoft have accounted for one-quarter of the gains generated by the S&P 500 index.
This is not only seen in the US. The Morgan Stanley Capital International (MSCI) China Index now has an information technology (IT) weighting of about 30%, with the stellar growth of Chinese tech stocks such as Alibaba and Tencent driving the index. Around the world, technological trends such as e-commerce, automation, miniaturisation, artificial intelligence (AI), machine learning, the Internet of Things, driverless vehicles and drone technology are becoming increasingly powerful economic forces – and Australian investors arguably have never needed the much wider range of global investment exposures more.
3) Dividends are not guaranteed
The shocked reaction in August, when Telstra warned the market to expect lower dividends in future, said it all about Australian investors’ love of share dividends. Reporting its FY17 result, Telstra maintained its FY17 dividend at 31 cents, but surprised the market with a new dividend policy: the company told investors to expect a full-year dividend of 22 cents, fully franked, in FY18, including both ordinary and special dividends. Prior to the announcement, the analysts’ consensus estimate had expected 29.6 cents in FY18.
Telstra tumbled from $4.33 to $3.87 on the news – a fall of 10.6% – and continued to slide, to $3.38, taking the company’s loss of value close to 22%. Not all of that market reaction can be sheeted home wholly to the lower dividend – for example, concerns about the impact of rival TPG’s new mobile network did not help – but the dividend surgery certainly did not impress investors.
The reaction showed how the extent to which many income-oriented Australian investors have come to rely on share dividends for income, in a low-interest-rate world. The problem with that strategy is that share dividends can never be assumed to be guaranteed at the prevailing level.
Investors with long memories would have remembered that even the big four banks – regarded by many as completely reliable sources of rising dividends – slashed their payouts in 2009 as bad debt provisions affected the ability to pay dividends. Commonwealth Bank cut its dividend by 14%, Westpac reduced its payout by 18%, and shareholders in ANZ and National Australia Bank suffered 25% dividend cuts.
The Telstra Tantrum demonstrated the price risk that income-conscious investors run when they treat shares as dividend milk-cows, but when the dust settled, Telstra was still offering investors a fairly decent yield, supported by the attributes of the dividend imputation system.
4) A stock ‘haircut’ is always possible
One of the major bugbears of sharemarket investing is that companies which disappoint the market with bad news can suffer severe share price falls in a very short period of time, wiping out not only tens of millions of dollars of market value, but also many months (if not years) of patient share price appreciation.
The share market is on edge during reporting season, ready to punish companies that report bad results – or fall short of expectations – with savage share-price markdowns. This is even more marked in the ‘confession’ seasons that precede each reporting season, when, if companies realise that they’re not going to meet their previous ‘guidance’ for the upcoming result (or the market’s profit expectations for the company) they must let the market know, in what is called a ‘profit warning.’
The market intensely dislikes profit warnings, and unexpected writedowns (a reduction in the value of what a company owns). The shares will be sold off: falls of 20% or more can be seen, in a day.
There’s been a host of shocking examples in 2017. In January, construction software group Aconex lost 45% in value in a day, after the company slashed its full-year profit forecast, citing the impact of Brexit and uncertainty around the election of President Trump.
Also in January, Tasmanian infant formula manufacturer Bellamy’s saw its shares slump by more than one-third in a day, after it slashed its profit guidance and dumped its chief executive, all while the board faced a shareholder revolt.
In May, 4WD accessories company Automotive Solutions Group – which had only joined the Australian Securities Exchange (ASX) in December 2016 – slumped 66% in two days, after warning that its profit would be hit by increasing competition and postponed orders. Automotive Solutions Group has not recovered, and has now received a takeover bid from its largest shareholder, AMA Group Limited.
Also in May, telecommunications firm Vocus, which owns the Dodo, iPrimus and Orcon brands, was marked down 26% in a day, after a 20% cut to its full-year profit guidance – just two months after confirming that guidance.
In July, online advertising aggregator Mitula Group suffered a 40% price plunge in just a morning, after warning that 2017 operating income would come in significantly lower than the previous forecast. In August, it was the turn of Australia’s largest pizza maker, Domino’s Pizza, which fell 19% after the company failed to meet its own sales and profit forecasts.
This can happen even on seemingly good results – it is the market’s expectation, and faith in previous guidance, that matters most. In August, steel producer Bluescope Steel watched its shares plunge by more than 20%, despite doubling net profit – after warning that 2018 earnings could be hurt by foreign competition and surging power prices.
There is no way of timing this kind of downturn – but if you’re worried about a potential downgrade, the weeks leading up to the reporting seasons (in January-February and July-August) are the most dangerous.