A reader this week asked if I could devote more columns to micro-cap stocks. Like so many investors, he wanted tips on the “next big thing” that could supercharge his portfolio.
I’ve had many similar requests over the years, notably when I edited the old Shares magazine. Readers would even call a few days before an issue appeared and ask if I could disclose which stocks would appear, such was the magazine’s influence at its peak. We never did.
Magazine covers that shouted “10 Hot Stock Under $1” always flew off the stands and those that promoted conservative blue-chip yield stocks tanked. Readers were loud and clear: more on unknown stocks and less on household-name stocks please!
Speculative stocks, of course, have their place for active investors and traders, and even for portfolio investors, provided they are only a small fraction of the overall portfolio. Investors must understand the risks of investing in micro-cap companies.
But here’s the thing: several conservative, even dull, blue-chip stocks have delivered exceptional gains over the past five years. Why chase risky micro-caps when you some of the bluest blue chips have delivered 20 per cent annually this decade.
Take Sydney Airport, a long-time favourite of this column. Its five-year total return (assuming distribution reinvestment) is an average annualised 25 per cent. Or gas infrastructure provider APA Group, which returned 23 per cent over five years.
Compare that with the average cash rates over that period – about 5 per cent – and you get a sense of how well so-called “conservative stocks” have performed.
It’s even better when one thinks about these returns on a risk-adjusted basis. Achieving 25 per cent annual returns from high-quality companies that own monopoly or duopoly assets is a lot better than chasing riskier mining stocks or other cyclicals.
Of course, investors have to pay up for the high-quality “conservative” stocks. Those with genuine economic moats or sustainable competitive advantages are by no means cheap. And gains in the likes of Sydney Airport and APA Group will be slower from here.
But the defensive yield trade still has plenty of room to run. Here are five stocks that suit conservative investors and can deliver low double-digit total returns:
1. Commonwealth Bank
The big bank stocks are under growing pressure as investors fret that they will have to hold more capital and suffer from a potential property-market collapse. A patchy economy, growing competition from fintech operators and, lately, concerns that the Australian Securities and Investments Commission will regulate bank culture are other headwinds.
A bearish view on the banks ultimately requires a bearish view on the housing market, such is the banks’ exposure to property-related lending and a property correction.
I expect price consolidation and weakness in parts of the sector, notably investment properties in Sydney and Melbourne. But the doomsday scenario of 40 per cent price falls in housing and banks following suit is badly overcooked. We’d need to see sharply higher unemployment, interest rates and housing supply, and banks curtailing lending in a big way.
Commonwealth Bank is the pick the banks for conservative investors. It is arguably the most capable of holding its yield and has a valuable technology advantage over its rivals.
Chart 1: Commonwealth Bank
Source: The Bull
2. Telstra Corporation
Love it or hate it, the telco giant is a mainstay for conversative investors. Telstra’s latest interim profit result again showed the power of its market position and ability to withstand growing competition in mobile telephony.
Its network is a formidable competitive advantage, despite recent outages, and is the reason Telstra has more pricing power than widely realised. Consumer demand for more and more data to download videos and other information is a huge long-term tailwind.
Like the Commonwealth, it has more capacity to engineer small dividend-per-share increases or at a minimum hold its precious dividend.
Chart 2: Telstra Corporation
Source: The Bull
3. Sydney Airport
Sydney Airport ticks some big boxes: it is a strong economic moat given its monopoly airport and is benefiting from growth in inbound Chinese tourism. How many other large businesses are growing customer numbers by more than 8 per cent each year in this market?
Sydney Airport’s critics say it is expensive, has too much debt, is hard to understand and has a rich valuation. They are right to some degree, but Sydney Airport continues to defy its critics and deliver exceptional operational performance and shareholder returns.
Expect slower capital growth from here – the big gains in infrastructure stocks have run their course. A bigger pullback or consolidation in the stock would not surprise given the extent of its gains. Current investors should hold on for the ride and prospective ones should wait for a market pullback to buy at lower prices.
Chart 3: Sydney Airport
Source: The Bull
4. Transurban Group
Like Sydney Airport, toll-road operator Transurban has fabulous assets and a hefty price tag. It fully owns the CityLink tollway in Melbourne, and fully or partially owns several key roads and tunnels in Sydney, Brisbane and the United States.
Toll roads are a great defensive business when consumers are willing to pay their tolls to use the road, and lousy for investors if they vote with their cars and avoid them – witness some of the spectacular failures in toll roads over the years.
Nevertheless, Transurban looks well positioned to lift its dividend over the next few years as growing traffic congestion increases toll-road volumes and as road widening and other strategic initiatives boost earnings. A high valuation makes it hard to buy at the current price but it’s the type of conservative stock that can reward patient investors in the long run.
Chart 4: Transurban
Source: The Bull
5. Sonic Healthcare
The pathology and radiology provider has had a tough 12 months, falling from a 52-week high of $23.73 to $17.88. The market sell-off and lower earnings guidance for 2016-17, due to healthcare fund cuts targeting pathology, diagnostic imaging and radiology, hurt its price.
Sonic said in December that the Federal Government’s Mid-Year Economic and Fiscal Outlook, with its unexpected announcement of Medicare fee cuts, would lead to small single-digit declines in revenue and underlying earnings, if passed in the Senate.
My hunch is that investors have over-reacted to the potential change. Sonic’s Australian, United States and United Kingdom divisions are performing solidly, although the imaging business (a smaller proportion of revenue) was trading below expectation, in part because of regulatory uncertainty.
A median share-price target of $19 suggests Sonic is a touch undervalued at the current price, based on consensus estimates. Five of 12 brokers who cover the stock have a buy recommendation, four have a hold, and three a sell.
Sonic can do better than the market expects in the next two years and the long-term theme of an aging population needing more blood tests, X-rays and other procedures is a strong tailwind.
Chart 5: Sonic Healthcare
Source: The Bull
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at April 7, 2016.