Diversification opportunities for 2018

5 minutes  

Take outs:

  • When investing in international equities make sure you are not adding more of the same to your investment portfolio.
  • Genuine offshore diversification requires investing in high growth sectors which the ASX has limited exposure to.
  • Keep away from FAGAM stocks and ‘unicorns,’ which may have trouble sustaining their momentum, in favour of well researched tech and healthcare stocks selected by investment professionals.

International technology, healthcare and retail stocks may offer some exciting diversification opportunities for 2018, according to Gino Rossi, back-up global SMA portfolio manager at Arnhem Investment Management.

He notes that with Australian financial and resources companies making up 59% of the ASX 200 index the prevailing wisdom for those wanting to diversify is to just go overseas. But financial and resource stocks also have a substantial presence in global benchmarks. In fact, they represent 30% of the MSCI World ex Australia Index.

“So when you go overseas, you're not really diversifying,” says Rossi. “You're adding further to your bank and resource exposure.”

He points out that Australian and global banks are highly correlated. “They’re driven very much by the yield curve and yields are correlated globally. You may have also heard of Basel regulation. Regulation of banks has become more unified around the world.”

Rossi says Australian and global resource stocks are even more correlated as they are influenced by global commodity prices and trading processes.

Also, by diversifying into financials and resources offshore, Australian investors give up higher yields and local franking benefits.

“Our opinion is that when you go overseas, if you're just getting off-the-shelf products from a manager, you're not diversifying out of Australia as well as you could be,” says Rossi.

An alternative stock approach

To gain genuine diversification offshore, Rossi believes investors should look at high growth sectors which the ASX has limited exposure to.

One of these is technology. “Despite warnings of a ‘tech bubble 2.0’, this sector generally doesn’t look overvalued,” he says.

That’s if you keep away from the FAGAM (Facebook, Apple, Google, Amazon, Microsoft) stocks which Rossi believes will have trouble sustaining the momentum they've enjoyed in recent years.

“They're very crowded trades. You’ve got a lot of ETFs in there. It's a default position for many investors.”

Arnhem is also avoiding what it calls “unicorns”, that is a start-up company valued at over US$1 billion (e.g. AirBNB, Uber, Snapchat), because of their extreme valuations.

Tech stocks you may not have heard of

Instead, it’s investing in technology companies the average layman probably hasn’t heard of – for example, in Nvidia, the market leader in graphics processing units (GPUs).

“If you want to play one of the latest video games, you need a very powerful GPU to give it those lifelike graphics,” says Rossi.

“This is a very high growth market. Nvidia dominates and is getting a lot of traction because the number of applications that GPUs can be used in are growing.

“There’s also an increasingly realisation that GPUs give you additional processing power and a different processing ability to central processing units. They're being used to beef up the computing power for applications like artificial intelligence.”

Other technologies Arnhem is investing in include extreme ultra violet lithography (through ASML), augmented/virtual reality (via Activision), cloud data growth and security (through F5 Networks).

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Healthcare throws up some options

Rossi highlights many exciting advancements in the healthcare space, for example, in genetic sequencing and CAR-T therapy.

“The problem is we're professional investors,” he says. “We can't just invest because it's a good idea or the science is great. Our view is the market is too excited too early. We want to jump in, but we're just not confident that we're going to make a return, so we're sitting back.”

That said, Arnhem is investing in companies such as Align Technology which has exposure to clear aligners, an alternative to metal braces for crooked teeth.

Clear aligners offer consumers better treatment times, aesthetics and convenience – users can take them out to eat, at night or to attend a special event. Plus, they enable dentists to scan a mouth digitally and predict where teeth will move.

“The market is excited, and we think rightly so,” says Rossi. “This is the story of a product which is superior. People are going to switch over. It's just a matter of training up dentists.”  

Rossi is also keen on stocks involved in GLP-1 drugs, immuno-oncology treatments and healthcare IT.

Retail doesn’t miss out

Turning to retail, he sees “a very ugly picture” for traditional retailers in a post-Amazon world. “In the past, you could roll out new stores, take margin and you had some relatively easy growth. The game has changed. Now it's about cutting costs and driving volume.”

He says online capacity doesn’t grow the pie. “It just means extra costs and investment in the supply chain to be able to compete. It's more cost for the same business.”

Rossi also expects the “Amazon effect” to keep driving consolidation among retailers. “You're probably going to be left with one major player in each category. If you can pick who that's going to be, that can be quite lucrative. But we think it's a bit early to be playing that game.”

Turning to particular international retail stocks, Rossi likes home improvement retailer Home Depot because it’s well-run, has healthy margins and is benefiting from a strong housing cycle in the US.

“It’s been Amazon-proof to date and we think there are several further growth opportunities the market doesn’t appreciate. It just seems a very solid shareholder friendly business that'll keep going.”

In addition to leather goods company Tapestry, Rossi is also partial to “off-price” retailer TJ Maxx which buys excess inventory from major apparel and accessories brands across the world and resells it at 20-60% discount to department stores.

However, he struggles to view Amazon as an investment opportunity. “Just because Amazon can disrupt someone else's profit stream doesn't mean it can capture that profit stream for itself,” he says.

“We don’t see Amazon becoming profitable in the foreseeable future and for a stock sporting a US$550 billion market cap and trading at 140x earnings, this is a problem.”

Listen to the full presentation ‘2018 investment outlook - Technology, health and retail’ or click here if you would like to speak to us.


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