Portfolio Themes for 2018

2017 is nearly in the rear-view mirror, so in this note we look to 2018 and discuss our preferred investment themes and ideas for the year ahead. One of the observations from our macro outlook is that some of the trends from 2017 should continue into 2018. In particular, Australia is expected to stay de-synchronised from other developed markets from an economic and monetary policy perspective. Hence, the ‘declining AUD/USD’ and ‘global over local’ theme remains relevant. New themes we are introducing include ‘inflation beneficiaries’ and those with ‘balance sheet appeal’. Additions to our preferred lists this year include Aristocrat (global), QBE and Qube Holdings (inflation), Alumina (balance sheet) and Austal (structural).

We continue to see the Australian dollar (AUD) versus US dollar (USD) exchange rate declining, to US$0.72 by the end of calendar year 2018. Many of the reasons for forecasting a lower AUD in 2018 are familiar – narrowing interest rate differentials between the US and Australia, a further modest slowing in China’s growth rate, and our expectation that most commodity prices will track sideways to lower over the year. Another factor could be widening corporate tax differentials with the US, if the US government is successful in legislating tax reforms. For pure currency exposure, we suggest an exchange-traded fund such as the Betashares US Dollar ETF (USD.AXW).

_{^{Source: Ord Minnett Research}}

The global economy is expected to sustain above-trend 3.2% real GDP growth in 2018. Compositionally, this assumes better growth in emerging markets excluding China (primarily India and Latin America), a modest slowdown in China’s growth, and a steady Europe and US. By comparison, economic growth in Australia is set to come in at a below-average pace of 2.8%. Corporate earnings growth overseas is also forecast to be double that available in Australia over the next 12 months, at 10% versus 5%. Based on our currency views, regional earnings growth forecasts and outlook for offshore equity markets, we think having some global exposure still makes sense. Slot machine manufacturer, Aristocrat, is a new addition to this list, with around 80% of revenues sourced offshore, primarily in the US, but also in Asia and Europe. The company is also diversifying its revenue sources by investing in the high-growth digital space as consumers shift towards online gambling channels. The acquisitions of Plarium and Big Fish will make Aristocrat the second largest Social Casino publisher globally by revenue, and will improve its pro-forma recurring revenues from 57% to 65%. Other options for exposure to offshore growth include Boral (building materials provider leveraged to US construction and re-build activity, as well as local infrastructure works) and Ramsay Healthcare (hospital operator with a strong balance sheet to strengthen its existing presence in Europe).

_{^{Source: Ord Minnett Research}}

Given financial stability risks in Australia, and the patchy track record our market has had in meeting earnings expectations, it is hard to go past companies with sound balance sheets. Our view is that these companies should offer some defensiveness should financial stability risks increase, yet still have flexibility to pursue earnings accretive strategies (eg, acquisitions, buybacks). ANZ is our preferred bank given it has one of the stronger capital ratios of the major banks, with its CET1 ratio at 10.6%, opening up the possibility that it could look at capital management options early in CY18. Rio Tinto and Alumina are our preferred resources exposures given their relatively undergeared balance sheets, valuation upside, and exposure to our preferred base metal, aluminium. Service Stream is currently in a net cash position, which it is likely to use for bolt-on acquisitions, supplementing its revenues from the NBN rollout, but giving it flexibility for capital returns as well. Similarly, Orora has capacity under its net debt/EBITDA target of 2.0–2.5x to pursue further bolt-on acquisitions.

_{^{Source: Ord Minnett Research}}

It is anticipated global inflation will rise from 2.0% to 2.2% in 2018, driven by input cost pressures (namely, energy prices) and tightening labour markets. Yet the scene in Australia is different, with spare capacity in labour markets and increasing competition creating disinflationary risk. We seek companies that can hedge against both outcomes – that is, their ability to push through price increases can either offset local disinflationary pressures or absorb the risks emanating from rising global inflation. AGL Energy is favourably exposed to higher electricity prices – one of the few sources of inflation in Australia – having pushed through price increases to retail customers in the past year. Another beneficiary of higher energy prices is Oil Search. Oil prices have risen as OPEC extends its output cuts to the end of 2018, while LNG prices have increased after regulation was introduced to restrict Australian exports. Oil Search is one of the few producers able to take advantage of this pricing environment, given it is producing above nameplate capacity and is able to sell the additional tonnage on spot markets. We may be a little early on QBE, with the possibility the new CEO may re-base guidance, but we think the share price could be nearing a bottom. Our analysts think there is an increased chance that global insurance premiums will rise following 3Q17 losses sustained by the industry. Furthermore, higher global inflation will induce higher bond yields, which would benefit QBE’s investment yields. Finally, we see Qube Holdings pushing through higher port infrastructure charges following a move by one of its key competitors, creating some revenue upside in its Patrick’s division. We expect this could also increase the appeal of its Moorebank project, helping it to lock in further tenancy agreements next year.

_{^{Source: Ord Minnett Research}}

These are companies that may not deliver earnings upside in the near term, but we are willing to be patient around the investment thesis, given leverage to longer-term structural trends – such as the ageing population, growth in superannuation assets, infrastructure and renewables. One new addition to this list is Austal, a shipbuilder. Our positive view is based on the company being well positioned to benefit from a strong pipeline of opportunities in the defence sector, especially given the geopolitical climate.

_{^{Source: Ord Minnett Research}}

This list, on the other hand, outlines companies where we see downside risks developing. We elaborate on the reasons why below.