(TUESDAY 22ND NOVEMBER - JAMES GERRISH - 7:50am)...The DOW JONES lost -247pts overnight while the S&P 500 fell -1.86%. European mkts were sharply lower (FTSE down -2.62%, German DAX off -3.35%, French CAC down -3.41%) while locally, the SPI FUTURES mkt is pricing a lower open down -65pts when trading kicks off here this morning.
Yesterday, the S&P/ASX 200 fell -13 pts to close at 4163.
DOW JONES - It was 89th day for the year we've had triple digit moves in either direction on the DOW - shows the volatility we're dealing with at the moment and supports our preferred strategy of manufacturing returns through a 3 tiered approach.
1. Have an allocation to stocks paying high income now which might be offset with potentially lower growth in the future. Telstra, Banks, TTS, Hyrbids, etc
2. Have an allocation to stocks paying relatively lower income now but are likely to increase dividends over time due to strong earnings growth. MTS, FWD, WES etc
3. Sell call options over a portion of the portfolio to manufacture additional income.
By a using a strategy such as this, we can expect a grossed up dividend income of around 8% now with expectations that it will grow in the future, we can expect to generate 2% a month from the sale of options and if we do that on 50% of the portfolio, 6 months out of 12, then that ads another 6% to the total portfolio return over the year. That's 14% before we ad in capital gains or in the event the mkt goes backwards, we've got a buffer against capital loss.
That's obviously our broader strategy or structure we're investing towards however its critical that we aim to time the mkt as best we can. From a technical standpoint overnight, the DOW JONES did break through support overnight which is obviously a negative. Gold and other commodities were hit pretty hard as the risk off trade really unwound.
WHY WE LIKE THE BANKS...
It all comes down to value which is on offer at the moment due to concerns coming from Europe. The bank sector is currently trading on a forecast PE or 10x v long term average of 12.6x. As the chart below shows, the sector tends to revert back to the averages from an overbought or oversold state.
Some would obviously argue that the current discount is justified given the issues currently facing the banking sector which include subdued credit growth, higher costs of funding, normalization of bad debts impacting the ability for earnings growth and earnings from wealth management divisions clearly under pressure.
At the moment, the sector is trading at an 11% discount to market. Historically, it trades at a 7% discount to market however that has ticked up to a peak of 15% during the GFC.
So in that context, banks can get cheaper from here but not significantly if history is a guide (and it should be).
Couple this with a grossed up forecast yield of 10.5% across the sector + we have the ability to write options against the holding and the banks fit the profile for our strategy.
If we look at the current yields in a historical context it becomes clear that they won't be sustained at these levels over the long term. One of two things can happen here.
Banks cut their payouts or stock prices rise. Given banks are recording record profits and even though times are getting more difficult, earnings are still growing + payout ratios are not stretched (74% the highest for WBC and 64% the lowest for ANZ) - so it seems we can be fairly confident that dividends will continue to flow at current amounts or higher. The obvious conclusion here is that prices will tick higher over time and although there are short term concerns, these will pass and the investment case in the banks at the moment remains fairly compelling.
So whats our preferred exposure? To chose 1 it would be ANZ but in reality the performance within the sector is likely to be fairly correlated.
We like ANZ given expectations for earnings growth derived largely from its Asian expansion plans ( it now generates +15% of earnings from Asia).
Using the Lynch Model which we find helpful in determining bank valuations ANZ comes out on top. The Lynch Model seeks to rank a banks attractiveness if the sum of its annualized earnings growth and gross dividend yield is greater than the forecast PE. In the case of ANZ, it has an average EPS growth rate plus dividend yield of greater than 18% and trades on forecast PE of 9x - clearly an attractive outcome.
MODEL PORTFOLIO UPDATES
None this morning
AUSTRALIAN STOCK PRICES OVERNIGHT
In New York, News Corp fell by US$0.22 to US$16.60, equivalent to A$16.86, A$0.06 above its last close on the ASX.
ResMed fell by US$0.59 to US$25.89, equivalent to A$2.63, A$0.01 below its last close on the ASX.
In London, Rio Tinto fell 185.58 pence to £30.90, A$2.95 lower in Australian currency terms.
BHP-Billiton fell 90.0 pence to £17.80, A$1.43 lower in Australian currency terms.
Henderson Group Plc fell 6.7 pence to £1.05, A$0.11 lower in Australian currency terms.
