Saturday 16 December 2017

Expert advice on building an investment portfolio to withstand uncertain times

The 'Trump Bump' may have helped equity markets hit record highs at the end of the year but fears over US debt to GDP ratios, the spectre of stagflation and potential disruption to global trade could make it a tricky 2017 for investors. However, healthcare, real estate and an increase in mergers and acquisitions may offer opportunities

Healthcare offers a high dividend yield with defensive earnings growth
Healthcare offers a high dividend yield with defensive earnings growth

Ross McEvoy

It was an extremely volatile year. Global equity markets declined by over 16pc in the first seven weeks of the year before rallying at 30pc. The so-called 'Trump Bump' has now pushed equity markets to record highs. But it is possible the market is overly discounting the potential uplift from Trump's proposed new policies while ignoring the risk of a substantial increase in the ratio of debt to GDP in the United States.

A considerable rise in interest rates in 2017 could bring this risk to the fore or even raise the prospect of stagflation (persistent high inflation combined with high unemployment and stagnant demand in a country's economy).

And it would be foolish to ignore the potential disruption to global trade relationships if Trump's protectionism policies are imposed. The outlook will hinge on whether Trump's proposed corporate and personal tax cuts are implemented in the first half of the year.

Global inflation expectations have risen sharply in recent months, particularly in the US. Despite this, there will be a clear divergence between the European Central Bank and the Federal Reserve in 2017. The Fed is forecasting three rate hikes in 2017, but for Irish deposit holders it will be another year of effectively zero interest rates.

In December, the ECB committed to continuing its monthly purchase programme until December 2017. Therefore, it is unlikely we'll see any discussion of rate rises in Europe until the second half of 2018 at the earliest.

Finally, Europe has a heavy election calendar in 2017 that will be dominated by four important events: the Dutch general election (March), British local elections (May), the French elections (May), and the German election (September).

The growing disillusionment with governments globally has led many to extrapolate the US Presidential and UK referendum result to every important future election. Without doubt, 2016 was a year for backing outsiders - but 2017 could be one for sticking with the favourites.

In France, conservative Francois Fillon is well ahead of Marine Le Pen in the polls and is odds-on to be elected. Again, in Germany, there is a risk a leftish coalition could also oust Merkel, but this would not be the consensus scenario and she again is odds-on to be elected.

While these elections present heightened uncertainty, in the absence of a large critical shock, we think the improvement in Europe should continue in 2017.

So, how should investors navigate these uncertain times? We recommend constructing portfolios around these three themes.

Rebound in Healthcare

Healthcare is one of our favoured sectors because it offers a high dividend yield with defensive earnings growth.

The sector is trading significantly below its long-run average P/E ratio and below the market multiple for the first time in five years, despite offering a superior growth profile.

Where it looks particularly cheap is against consumer staples, which trades at a 30pc premium despite offering a similar earnings outlook.

We also believe the Trump victory offers more opportunities than downside risks. For instance, Trump is reportedly considering naming Jim O'Neill as FDA commissioner. O'Neill is on record as saying that he wants to speed up how drugs come to the market and has called for eliminating the requirement to establish that new medicines are effective before approving them for sale.

Within healthcare, we favour companies that invest in research and development. Growth by acquisition can also play a part, but on its own it cannot be sustained.

On the lower-risk end of the scale, we recommend Roche, which is a leading innovator in oncology, as well as immunology and infectious diseases. With a prospective dividend of 3.7pc that is well-supported by high free cash flow yield, the stock meets the requirement for income-seeking investors.

Those with higher-risk appetites could look at Allergan, the specialty pharmaceutical whose deal with Pfizer recently fell through. Allergan's core business is growing at high single-digit top line.

Furthermore, we see potential for earnings growth through acquisitions, share buybacks and upside from an underappreciated pipeline.

For those who prefer to invest in the overall healthcare industry without taking stock specific risk, we recommend the Health Care Select SPDR Fund ETF. It encompasses pharmaceutical and biotechnology stocks as well as the industry payers, diagnostics and technology.

Search for Income

For investors searching for income we believe Green REIT (Real Estate Investment Trust) and AIB subordinated bonds present attractive income opportunities.

The European real estate sector has declined by over 10pc since September due to a global rotation away from interest-rate-sensitive stocks. The European-wide sell-off has dragged Green lower, which in our opinion is unjustified.

The share price decline has left their portfolio trading at about a 20pc discount to our June 2017 NAV (Net Asset Value) forecast.

On top of this, we forecast a dividend yield of close to 4pc in 2017. It is worth noting that this 20pc discount to NAV compares against most non-listed Irish funds which trade at a small premium to NAV.

Considering its grade-A office portfolio, solid balance sheet, development momentum and potential of some benefit from Brexit, we believe Green should close the discount to NAV as it continues delivering on its business plan.

We also favour the AIB Subordinated Bank Bond, which pays an annual coupon of 4.125pc and has a fixed maturity date of November 2025. AIB also has the option to call the bond in November 2020.

We are upbeat on AIB's prospects and believe the credit profile would be enhanced by a return to the equity markets in 2017.

AIB's recent trading update underpinned our bullish stance on their credit. The fully loaded capital ratio, net interest margins and new lending drawdowns were all ahead of expectations.

Surge in M&A Activity

A possible repatriation of overseas cash by US companies coupled with a strong US dollar could drive a marked uplift in mergers and acquisition activity for European and UK companies in 2017.

We saw signs of this trend emerge this year as News Corp swallowed up Wireless Group and Fyffes was acquired by Sumitomo Corporation. Moody's estimated there was $1.7 trillion of cash held offshore at the end of 2015, so there is money to spend.

One stock where takeover rumours could resurface is Smurfit Kappa. Smurfit Kappa came under bid speculation from US rival International Paper in 2015, although nothing official was confirmed.

With the dollar approaching 14-year highs against the euro and International Paper's share price within touching distance of record highs, this may prove an opportune time to make an approach.

Discounting a bid, we would still view Smurfit Kappa as a buy based on its attractive dividend yield, strong free cash flow and unwarranted discount to the sector.

You might expect me to say this, but investors looking to play this theme could also consider the Goodbody Smaller Companies Fund.

The Smaller Companies Fund offers exposure to a diversified portfolio of small/medium-sized companies that are growing strongly and represent attractive investment opportunities.

Ross McEvoy is an Investment Manager with Goodbody

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