Nucleus Insights : Australian Housing – Boom and Doom

Grantham: The cost of a conscience

I belatedly found this slide deck from a GMO presentation from earlier in the year talking about climate change and investing at the LSE: http://www.lse.ac.uk/GranthamInstitute/news/the-mythical-peril-of-divesting-from-fossil-fuels/

The main chart that caught my eye was a one on the long-term effect of excluding an entire sector from the index :

Basically, my interpretation is that if you decided to exclude an entire sector from your investment (presumably for ethical reasons) over the long term:

  • Most of the time the difference in performance will be negligible
  • A lot of the time you will beat the index
  • Even if you happen to pick the worst sector, we are talking about 0.2% underperformance

This supports my thoughts in a recent post (noting that I am talking cutting out significantly more stocks):

So, how much negative performance are we talking?

It is hard to say with any precision.

The key question is how much of the market you are removing.  At Nucleus, we let investors customise to their own needs and exclude stocks that don’t fit their own ethics. A common ethical screen at Nucleus is to remove any stocks involved in cluster munitions from the portfolio.  The effect of this is only to remove a few stocks from the universe of 1,600 and so is unlikely to have any meaningful effect on performance. 

Investors can then choose to remove companies involved in any weapons manufacturing. This will also remove not only a number of large US defence contractors but also stocks like Boeing and so the effect will be greater.

If I run simulations and assume about 25% of all stocks are excluded, sector outperformance is relatively random and that investment managers have some skill then you can pencil in a typical performance hit of less than 0.5% over the long term.  In individual years the difference can be much greater, a 2-3% difference in performance would be quite common.   

If you cut out more or less the effect changes – but not linearly, the expected performance gets exponentially worse as you remove more stocks.  Also, the more skill that you think managers have, the greater the effect is likely to be as well. 

A few things to note with the Grantham numbers:

  1. Both charts have very long time frames. The year to year performance differences are much (much) larger.
  2. The sectors chosen are today’s sectors. I’m guessing that being “ex-IT” (i.e. not investing in any Information Technology stocks) in 1925 wasn’t a significant issue. I doubt it makes that much difference to the analysis, but it may.

 

And some more thoughts from my earlier post on the usefulness of ethical investments:

If there is a cause you are passionate about and you want to support companies in that area, there are four ways you can support that cause, in order of most helpful to least helpful:

  1. Make a donation. Are you trying to help or are you trying to make money? If it is the first then by donating you can feel good straight away, you get a tax deduction up front (rather than waiting to book a capital loss when you sell shares!).  Donating directly to companies is not generally tax deductible – but I’m guessing if your cause is ethical then there will be industry bodies that are tax deductible.
  2. Buy the product yourself. Most companies want more customers rather than more shareholders – and the ones that don’t you shouldn’t be investing in.
  3. Buy shares from the company in a capital raising. That way your money will actually go to funding the company expand or its research and development.
  4. Buy shares on the market. This is the least helpful way of helping the company. All you have done is transferred money to another investor. 

Final word

  • If you want to make the world a better place using your money, consider other ways first – would a donation be more helpful?
  • If you want to ensure your investments don’t make the world worse, then find a product that avoids stocks that align with your values or use one like the Nucleus fund that allows you to customise your ethical choices.
  • If you are buying free-range eggs, fair trade coffee or ticking the box for green energy, you don’t expect a discount vs the alternative.  Think of ethical investing in the same way – expect to give up a little performance, and occasionally you will be pleasantly surprised when it outperforms.
  • I’m sure there are plenty of jobs that you wouldn’t do, regardless of how much more money you get paid.  Why should your investments be any different?
  • Check the fees. Please. If not for yourself then do it for me. Few things in the investment world irk me more than seeing ethical funds sold for unethical fees.

Nucleus Insights : Good Defence is the Best Offence.

2Q reporting season

Good breakdown by Credit Suisse (via the Wall Street Journal) on where the US earnings growth is coming from:

Oil is good for a small set of companies, bad for the rest. But unless the oil price falls the earnings growth will be repeated in 3Q and 4Q.

Taxes are one-off but set to continue for at least another 6 months. I suspect there will be effects for the next few years as companies work out how to game the new rules more effectively.

Buybacks are just accounting treatment, but with record buybacks likely to continue there is probably another year or so of positive effects from them.

The US dollar effect will reverse a little in coming months.

It is late in the economic cycle, so you don’t want to get too carried away with the positives.  But its hard to find too many negatives in US corporate profits for the next six months.

Source: Nucleus Wealth, Factset

 

Chinese battery factories in Germany

The shoe is on the other foot for a change with a Chinese company (recently listed Contemporary Amperex Technology – the world’s largest EV battery manufacturer) announcing a new factory in Germany yesterday. From Bloomberg:

CATL and the state of Thueringia in central Germany Monday announced a plan to build a 16-gigawatt lithium-ion plant close to the region’s capital Erfurt. … CATL’s decision to choose Germany for its first battery factory outside China is a chance to bring electric mobility “faster to the roads,” said the Frankfurt-based VDMA machine makers federation. CATL picked Germany to be close to the production centers of BMW AG, Volkswagen AG and Daimler AG

It seems more and more likely that China will push battery technology hard with state support – and as the world’s largest importer of oil, it makes sense for China to do so. If this happens, we could see a similar outcome to solar power where cheap Chinese solar cells effectively drove manufacturers from other countries out of business.  Bloomberg concurs: 

A push by the EU Commission to create an “Airbus” of battery-cell production — meaning participation from multiple trade bloc states — has stalled, mainly on expectations that Asian rivals are better positioned to lower the costs of a commodity product like battery cells.

From an investment front is that the faster battery prices fall, the more viable solar becomes and the more viable electric cars become.

My rough numbers suggest that the tipping point is fast approaching:

Levelised Energy Costs

 

June Performance

June continued to see positive returns across our portfolios,  our Australian fund was up 2.3%, International up 1.3% and the tactical funds up between 0.3% and 0.9%.  These returns were supported by a fall in the Australian dollar, which added significantly to performance in June.    

June was a strange month from a performance perspective. World share markets fell in US dollar terms, on the back of weakening fundamentals in Europe and rising trade tensions, but the rising Australian dollar more than offset those falls for Australian investors.  However, the Australian share market added 3.7% – in spite of weakening Australian fundamentals and (as Australia is a small, open economy) greater exposure to a trade war.

Australian shares are now up almost 10% in 3 months, a peculiar outcome over a period where the Australian dollar has fallen 4% and Australian forward earnings have been downgraded by 3% (vs upgrades of 6% in the US).  This means Australian valuations are now 10% higher than the world average. Over the past 15 years or so, Australian valuations of 10% more/less than the world has represented a limit for the Australian market and a sell/buy signal:

Australia Valuation vs World
Source: Nucleus Wealth, Factset

Now, this valuation method is pretty simplistic, but it illustrates what we are seeing across a range of other metrics. A counter-argument would be that if earnings growth and the outlook was stronger in Australia then the higher valuations could be justified. This is not the case – in fact, Australia earnings continue to diverge lower vs world earnings:

World EPS vs Australian EPS
Source: Nucleus Wealth, Factset

And, if you just look over the last month, examining how earnings forecasts have changed, it is clear that Australia and Emerging Market earnings are suffering the most:

Earnings revisions by region and sector
Source: Nucleus Wealth, Factset

So, this begs the question: is the stock market seeing some other strength that isn’t being reflected in analyst forecasts or foreign exchange markets? 

Our take is no.  The fundamentals are moving largely in the direction that we have discussed on many occasions: US strong, Europe weakening, Chinese growth slowing, Australian earnings down and further downside risk from a slowing China, declining property market and slower mortgage growth.

From time to time markets will dislocate from fundamentals before regaining their senses. In our view, June is an aberration rather than a sign that Australia is turning around. 

The dilemma we are trying to address in the portfolios is how to get enough exposure to the final leg of the bull market while maintaining downside protection in case markets unravel earlier than expected. As a result our portfolio is a little bi-polar at the moment, with a range of higher quality stocks that are exposed to continued US growth offset by a larger number of defensive holdings. As many traditionally defensive sectors (utilities, REITs, infrastructure) are expensive, our defensive holdings stretch across a range of consumer staples sectors.

We are sitting on a considerable cash balance in all of our Tactical portfolios – our Tactical Growth fund targets a 10% exposure to cash and bonds, our weight is currently 35%.  We have even more cash in the more conservative funds.  We have been holding part of that cash in a range of international currencies and so have benefitted from the falling Australian dollar.

For more information on how we position client portfolios to help maximise upside but more importantly, mitigate potential downsides, check out our upcoming live webinar on the topic.

June Performance

Nucleus June performance
Source: Nucleus Wealth, Linear, Factset

The returns above include fees and trading costs on a $500,000 portfolio. Note that individual client performance will vary based on the amount invested, ethical overlays and the date of purchase. The benchmark returns do not include fees. See performance section below for relative returns.

Individual Stock performance

This month Technology service providers like Google outperformed, but Technology manufacturers (like Micron and Applied Materials) gave back some of their May gains with looming trade war fears. Hardest hit was WH Group (HK) which is a large pork importer and is expected to be affected by the retaliatory tariffs. Despite AbbVie’s poor showing, the remainder of the Health sector lifted the performance of the portfolio.

International Stock performance
Source: Nucleus Wealth, Factset

Domestically the defensives of Woolworths and Wesfarmers(Coles/Bunnings) outperformed while the Telstra and hospital operator Ramsay derating continued. The greatest detractor to overall portfolio performance was our underweight in Banks which had a sharp bounce in the second half of June.

Australian Stock performance
Source: Nucleus Wealth, Factset

Investment Outlook

The fundamentals for shares look good, valuations don’t. Which, despite all of the ups and downs of the last few months is largely where we have been for the past year.

From an investment perspective, our three major concerns are:

  1. Europe: The major long-term issue is still the significant imbalances between Germany and most of the rest of the Eurozone. We note that recent issues in Italy are a symptom of the underlying problem  – not the actual problem.  Growth is also clearly weakening.
  2. China: Rebalancing is occurring, the question is how fast Chinese authorities allow it to occur. 
  3. Trump: Tax cuts are now impacting economic statistics which are looking strong, add to that an increase in US oil drilling and wage inflation is finally showing signs of life. These are both one-off gains and so the key risk is that the Fed over-reacts to the signs of strength.

Tactical Asset Allocation Portfolio Positioning

In our tactical portfolios, we own cash, bonds, international shares and Australian shares. We tend to blend these portfolios for clients so that each investor receives an exposure tailored to their own risk and income requirements.

The broad sweep of our asset allocation over the last 18 months was to ride the Trump Boom, switch into Europe in March / April last year as the US became overvalued and then switch back into the US as the Euro rallied and the USD fell. 

We have been using rallies in stock markets to reduce our holdings.

We remain underweight shares in aggregate, overweight international shares and significantly underweight Australian shares.

Over / Underweight positions by portfolio

Asset Allocation
Source: Nucleus Wealth

Tactical Foundation Portfolio

Our tactical foundation portfolio is designed for investors with lower balances, it uses exchange-traded funds for its international exposure rather than direct shares. The reason for this is parcel sizes,  you can’t buy half a Google (Alphabet) share directly and so we use exchange-traded funds which buy baskets of stocks instead. The tactical portfolio is a balanced fund, not as aggressive in its holdings as the growth fund nor as conservative as our income fund.

In May this fund increased by 0.9%.  The fund continues to be underweight Australian stocks.

Equities

We have a reasonable tech / IT exposure. The rising spectre of a potential trade war saw some significant price falls in this sector last month, before coming roaring back in May. We used April’s price falls as an opportunity to buy more. There are a number of smaller tech stocks that we own, in particular, a range of semiconductor stocks where we like the growth outlook. It is worth noting that part of the reason for Apple increasing the price of its latest phone is an increase in memory and components. This is a positive for semi-conductor stocks more generally, especially if a “feature war” breaks out in the smartphone space. We current hold a range of stocks that should be helped by this trend (Lam, Applied Materials, Skyworks, and to a lesser extent Cisco). We recently bought Alphabet (Google), Western Digital and Micron following recent price falls.

We are currently holding a larger than usual number of consumer staple stocks in our portfolio – traditional defensive sectors like Property Trusts, Utilities and Infrastructure are generally very expensive and so we are using a group of more stable industrial stocks like Kelloggs, Johnson & Johnson, Unilever, Kimberly-Clark plus a range of smaller stocks as an alternative. Over June we sold down more of our telco and infrastructure holdings.

We are underweight energy. In particular oil producers. This has not been a good call over the last six months, and our outperformance has been despite the underweight to oil rather than because of it.

We have been doing a lot of soul-searching on this call. The broad overview is:

  • Oil demand remains strong, and with (relatively) synchronized global growth we expect this to continue. 
  • The supply side is stronger. US production continues to reach new highs, Libya and Nigeria’s production recovered from interruptions. The lone negative is Venezuela continuing to decline. The ability of US shale oil to react quickly to higher prices means that supply is much more responsive than its been in the past. The US has now become an exporter of oil.
  • On the political side is where we see most of the action. OPEC and Russia are withholding supply to keep the price high, and US bombing in Syria plus Trump threats raise the spectre of sanctions returning to Iranian production.  
  • On the trading side, speculators hold record balances. This can be read two ways: (1) everyone else is going long, the oil price is going higher (2) the oil price has been pushed to current levels by speculators and will fall when they unwind their positions.

So, the question from here is whether we hedge our risk to political events by buying oil stocks in the face of fundamentals that suggest the oil price should be materially lower. If the risk were greater or the oil price lower, I would probably hedge. Given the current situation and current prices, we are going to stay underweight oil. But the debate rages on.

Our sole holding in the energy sector, Neste Energy is up around 70% over the past few months, which has shielded our portfolio from the rising oil price.  Neste is a Finnish oil refiner, making a significant investment in green technologies and is well regarded by a number of sustainable rating firms including being in the Global 100 most sustainable companies, the Dow Jones Sustainability index and CDP.

Performance to date

Portfolio performance can be cut a number of different ways. At its most basic level, you should care about the total return. At the next level, you should care about the total return relative to some sort of benchmark.

As you dig deeper, you should also be interested how the return was achieved – for example if your fund manager is taking lots of risk but only performing slightly better than the market then you should be concerned. Similarly, if you can get market returns but at a much lower risk then that may be an appropriate trade-off.

Our portfolios to date have been both out-performing benchmarks, and taking less risk. The disclaimer is that they have only been running for eleven months, and that is not enough time to make definitive judgements.

Nucleus Performance Statistics
Source: Nucleus Wealth, Linear, Factset

The returns above include fees and trading costs on a $500,000 portfolio. Note that individual client performance will vary based on the amount invested, ethical overlays and the date of purchase. The benchmark returns do not include fees. 

Nucleus Performance Statistics
Source: Nucleus Wealth, Linear, Factset

Epilogue

In summary, our view continues to be that Australian investors are better off holding international investments at this point in the cycle.

We retain relatively large cash balances to hedge against volatility and to look for a cheaper entry point. If markets continue to be weak then we will look to buy more equities. We are concerned about the potential for trade wars, which will be a key focus for us over the next few months.

Our intention is that our portfolio is positioned to take advantage of our key themes but minimise risk in the event that our themes take longer than expected to resolve themselves.

We usually find that big picture macro themes take a long time to resolve themselves in financial markets, but when macro theme resolve themselves they do so quickly – usually too quickly to reposition your portfolio if you are not already invested.

 

 

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

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May Performance

May continued to see positive returns across our portfolios,  our Australian fund was up 2% and the rest were up around 1% over the month. These returns came as protectionist trade rows flared and markets belatedly realised that European growth is slowing more sharply than expected – themes that we were relatively well positioned for. The Australian dollar took a breather during May, and so was a small negative drag on performance but has resumed its downward path in June.    

After dragging on performance during April, our technology holdings provided a boost in performance in May, with newly bought Micron +25%, Skyworks +14%, Apple +13%, Juniper +9%, Lam +7%, Alphabet (Google) +6% more than reversing losses from the prior month. Arguably, with their driverless car exposures, GM +16% and Aptiv +15% are also technology stocks. At the other end of the spectrum, we have a broad range of defensive stocks which underperformed over the month.

This performance difference highlights the dilemma we are trying to address in the portfolios – how to get enough exposure to the final leg of the bull market while maintaining downside protection in case markets unravel earlier than expected.

We are sitting on a considerable cash balance in all of our Tactical portfolios – our Tactical Growth fund targets a 10% exposure to cash and bonds, our weight is currently 35%.  We have even more cash in the more conservative funds.  We have been holding part of that cash in a range of international currencies and so have benefitted from the falling Australian dollar.

May Performance

Source: Nucleus Wealth, Linear, Factset

The returns above include fees and trading costs on a $500,000 portfolio. Note that individual client performance will vary based on the amount invested, ethical overlays and the date of purchase. The benchmark returns do not include fees. See performance section below for relative returns.

Investment Outlook

The fundamentals for shares look good, valuations don’t. Which, despite all of the ups and downs of the last few months is largely where we have been for the past year.

From an investment perspective, our three major concerns are:

  1. Europe: The major long-term issue is still the significant imbalances between Germany and most of the rest of the Eurozone. We note that recent issues in Italy are a symptom of the underlying problem  – not the actual problem.  Growth is also clearly weakening.
  2. China: Rebalancing is occurring, the question is how fast Chinese authorities allow it to occur. 
  3. Trump: Tax cuts are now impacting economic statistics which are looking strong, add to that an increase in US oil drilling and wage inflation is finally showing signs of life. These are both one off gains and so the key risk is that the Fed over-reacts to the signs of strength.

Europe

Overpriced Euro/Weak growth

The effect of an overvalued or undervalued currency is usually recognised when the currency makes a move but then seems to be largely forgotten. 

I take the view that undervalued or overvalued currencies for most supply chains:

  • Are quickly incorporated for commodity products
  • Take a lot longer to have an effect for more complex supply chains or services 

For example, if Boeing uses a European supplier for a part on their planes, then the Euro rising 10% over a few weeks is unlikely to see Boeing change suppliers immediately. However, leave the Euro at the elevated level for six months or so and then Boeing will start to look at other options – the less unique the part, the more likely Boeing are to switch. 

 

Euro / US Dollar

In my view, that is where Europe has been for about 18 months or so, and over April the effects have become apparent with Europe showing a number of signs of slowing and the Euro beginning to fall.

We have little exposure to domestic Europe, most of the stocks we own in Europe are multinationals. With a falling Euro and weakening economic picture, this has been the right positioning – we are not looking to add positions yet but we are starting to compile a list of stocks that we would like to buy if this theme continues. 

Underlying structural issues

There are structural problems with the Euro which have resulted in a depression in Greece and deep recessions in Spain and Portugal. Italy and France are struggling to meet deficit commitments. Germany is doing well.

There has been a rise in the support for anti-euro parties in most countries across Europe and Britain has voted to leave.  Italy now has a left / right coalition united primarily by Euro-skepticism.

I’m a subscriber to the Pettis school of thought on this one. Basically, Spain (as a representative of most of southern Europe) did not “pull” savings from diligent, pious German savers; but an underpriced Deutschmark on the creation of the Euro and German labour reforms caused a drop in German wages relative to German GDP. This meant German household consumption fell as a % of GDP which meant that German savings (being the other side of the coin) rose. These German savings were then “pushed” onto the rest of Europe.

Ordinarily, this would be solved by currencies: the Spanish currency would fall, and the German currency would rise. That way German workers would be wealthier and consume more, and Spaniards would have lower wages and be able to compete with German workers. But these countries are locked into the Euro which means that a different resolution is needed.

The solution to European problems (from Germany’s perspective) is for those other countries to stop borrowing the money that German banks keep offering them. Which basically amounts to recessions in Spain until wages in Spain fall low enough for Spanish workers to compete with German ones. The Pettis solution is for Germany to increase wages and spending to create household demand that will allow Spanish workers to compete.

It looks like Europe is going to continue to down the recession route. Which means a rise in voter discord and increased likelihood that Europe falls apart.

Political Catalyst?

We are not going to pretend to know the outcome of Italian issues. What can be observed is that:

  • Italy has elected a government who have objectives that are at odds with the European rules
  • Italy is large enough, and indebted enough to suck in the entire Eurozone and re-pose fundamental questions about the viability of the Euro
  • The underlying problems with the Euro have not been solved and so crises will emerge periodically

The question is whether there will be a showdown between the Italian government and the rest of the Eurozone in the next six months. The odds are high. 

US

Our core position is that Trump is trying to engineer a boom. It will not be sustainable and will likely be followed by a bust that leaves the US economy in a worse position but that is a future problem – positioning the portfolio for the boom is the current issue.

The proposed tax cuts are badly targeted by giving most of the benefit to the rich and to companies, trickle down is unlikely to work, the tax cuts are unsustainable, and they are only a short-term “sugar hit” for the US economy.  But it is going to be such a huge stimulus that you don’t want to stand in the way of it as an investor.

So, we want to play the boom, keeping a sharp eye on the bust.  Our portfolio positioning on this basis remains:

  1. overweight international stocks from an asset allocation perspective
  2. overweight stocks with US exposures – subject to valuation. The practical implementation of this has been buying non-US stocks that are exposed to the US.

China

In China broad data continues to weaken, suggesting that the rebalancing is occurring. However, the latest housing statistics show a bounce in construction – we are watching closely to see if this is a short-term issue or a sign of another wave of debt.

Currently, we are expecting it to be a short-term issue. 

China housing construction

A cut in the reserve rate in March and discussion of fiscal intervention might seem to some as a sign that the authorities want to return to debt-driven growth. Our view is that these measures are more about managing the downward glide path, potentially in the face of a trade war.

Over the medium term:

  • the shift to consumption-led growth rather than investment-led growth will require a greater shift than many recognize. This shift will be a significant negative for commodities/the Australian dollar
  • current growth rates are unsustainably high, inflated by rapidly increasing Chinese debt. The increase in debt has been required in order to hit the growth targets, so removing the growth targets will help refocus local party officials to more sustainable policies
  • activity still seems to be slowing.
  • the Chinese housing market appears headed into a soft landing thanks to macroprudential tightening so a possible path ahead for rebalancing is a muted not busting housing cycle that supports consumption while weighing on investment;

Our expectation is that China is going to continue to “glide” lower to try to normalize the capital expenditure to consumption in-balance – more to come on this over the next week.

China Capex to GDP

It is our view that the Chinese economy will continue to slow over the coming years – Japanese style lost decades, and low inflation/deflation remain more likely than a dramatic bust, which means a grind lower for commodities and the Australian dollar.

Our portfolio positioning on this basis remains:

  1. considerably underweight Australian stocks from an asset allocation perspective
  2. underweight resource stocks within equity portfolios

Tactical Asset Allocation Portfolio Positioning

In our tactical portfolios, we own cash, bonds, international shares and Australian shares. We tend to blend these portfolios for clients so that each investor receives an exposure tailored to their own risk and income requirements.

The broad sweep of our asset allocation over the last 18 months was to ride the Trump Boom, switch into Europe in March / April last year as the US became overvalued and then switch back into the US as the Euro rallied and the USD fell. 

We have been using rallies in stock markets to reduce our holdings.

We remain underweight shares in aggregate, overweight international shares and significantly underweight Australian shares.

Over / Underweight positions by portfolio

Asset Allocation
Source: Nucleus Wealth

Tactical Foundation Portfolio

Our tactical foundation portfolio is designed for investors with lower balances, it uses exchange-traded funds for its international exposure rather than direct shares. The reason for this is parcel sizes,  you can’t buy half a Google (Alphabet) share directly and so we use exchange-traded funds which buy baskets of stocks instead. The tactical portfolio is a balanced fund, not as aggressive in its holdings as the growth fund nor as conservative as our income fund.

In May this fund increased by 1.0%.  The fund continues to be underweight Australian stocks.

Equities

We have a reasonable tech / IT exposure. The rising spectre of a potential trade war saw some significant price falls in this sector last month, before coming roaring back in May. We used April’s price falls as an opportunity to buy more. There are a number of smaller tech stocks that we own, in particular, a range of semiconductor stocks where we like the growth outlook. It is worth noting that part of the reason for Apple increasing the price of its latest phone is an increase in memory and components. This is a positive for semi-conductor stocks more generally, especially if a “feature war” breaks out in the smartphone space. We current hold a range of stocks that should be helped by this trend (Lam, Applied Materials, Skyworks, and to a lesser extent Cisco). We recently bought Alphabet (Google), Western Digital and Micron following recent price falls.

We are currently holding a larger than usual number of consumer staple stocks in our portfolio – traditional defensive sectors like Property Trusts, Utilities and Infrastructure are generally very expensive and so we are using a group of more stable industrial stocks like Kelloggs, Johnson & Johnson, Unilever, Kimberly-Clark plus a range of smaller stocks as an alternative.

We are underweight energy. In particular oil producers. This has not been a good call over the last six months, and our outperformance has been despite the underweight to oil rather than because of it.

We have been doing a lot of soul-searching on this call. The broad overview is:

  • Oil demand remains strong, and with (relatively) synchronized global growth we expect this to continue. 
  • The supply side is stronger. US production continues to reach new highs, Libya and Nigeria’s production recovered from interruptions. The lone negative is Venezuela continuing to decline. The ability of US shale oil to react quickly to higher prices means that supply is much more responsive than its been in the past. The US has now become an exporter of oil.
  • On the political side is where we see most of the action. OPEC and Russia are withholding supply to keep the price high, and US bombing in Syria plus Trump threats raise the spectre of sanctions returning to Iranian production.  
  • On the trading side, speculators hold record balances. This can be read two ways: (1) everyone else is going long, the oil price is going higher (2) the oil price has been pushed to current levels by speculators and will fall when they unwind their positions.

So, the question from here is whether we hedge our risk to political events by buying oil stocks in the face of fundamentals that suggest the oil price should be materially lower. If the risk were greater or the oil price lower, I would probably hedge. Given the current situation and current prices, we are going to stay underweight oil. But the debate rages on.

Our sole holding in the energy sector, Neste Energy is up around 70% over the past few months, which has shielded our portfolio from the rising oil price.  Neste is a Finnish oil refiner, making a significant investment in green technologies and is well regarded by a number of sustainable rating firms including being in the Global 100 most sustainable companies, the Dow Jones Sustainability index and CDP.

We are underweight financials – mainly as we can’t find US financials that are cheap enough to justify purchasing. Insurance continues to be a sore spot, but we are looking to continue to build holdings in the sector with the view that after such severe losses in 2017 that insurance premiums will rise significantly.

Performance to date

Portfolio performance can be cut a number of different ways. At its most basic level, you should care about the total return. At the next level, you should care about the total return relative to some sort of benchmark.

As you dig deeper, you should also be interested how the return was achieved – for example if your fund manager is taking lots of risk but only performing slightly better than the market then you should be concerned. Similarly, if you can get market returns but at a much lower risk then that may be an appropriate trade-off.

Our portfolios to date have been both out-performing benchmarks, and taking less risk. The disclaimer is that they have only been running for ten months, and that is not enough time to make definitive judgements.

Nucleus Performance

The returns above include fees and trading costs on a $500,000 portfolio. Note that individual client performance will vary based on the amount invested, ethical overlays and the date of purchase. The benchmark returns do not include fees. 

One of the benefits of running large, globally diversified portfolios is that it is rare for single stocks to have much of an impact on performance. Our largest holding, Apple added about 0.6%  to the portfolio in May, followed by Footlocker and Micron:

Portfolio contribution
Source: Factset

Apple was up 13% and made up 4.5% of the portfolio = 13% x 4.5% = 0.6%. Footlocker was up over 25%, but makes up significantly less of the portfolio and so its contribution was lower.

Epilogue

In summary, our view continues to be that Australian investors are better off holding international investments at this point in the cycle.

We retain relatively large cash balances to hedge against volatility and to look for a cheaper entry point. If markets continue to be weak then we will look to buy more equities. We are concerned about the potential for trade wars, which will be a key focus for us over the next few months.

Our intention is that our portfolio is positioned to take advantage of our key themes but minimise risk in the event that our themes take longer than expected to resolve themselves.

We usually find that big picture macro themes take a long time to resolve themselves in financial markets, but when macro theme resolve themselves they do so quickly – usually too quickly to reposition your portfolio if you are not already invested.

 

 

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

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We have relocated !

Come drop by and say hi ! 

We are now located 9 / 401 Collins Street in the new WeWorks space.

Feel free to come by and ask us any questions on the fund or just come in for a coffee. Our team are more than happy to walk you through our funds and our latest performance. 

You can always contact us on

P: 1300 623 863

E: enquiries@nucleuswealth.com

or Book in a call with Head of Operations, Tim Fuller

 

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