He commented, ‘In 2016 equity markets held up surprisingly well given the seismic political shocks of Brexit, Trump and the Italian ‘no’ vote. It’s fair to say that we expect 2017 to be anything but dull given the level of global political and economic uncertainty that we still face – the flurry of elections due to take place across Europe, the UK triggering article 50 and the implementation of Donald Trump’s fiscal policies.’
McGarry continued, ‘With this backdrop, investors could be forgiven for thinking 2017 will be a dismal year for equity returns. But we don’t think this will be the case. We think there’ll be a rotation out of some of the sectors that did well last year, into those that did less so – and investors could reap the benefits.’
The first stock he selected is housebuilder Barratt Developments. He commented, ‘despite the sector selling off aggressively in the aftermath of Brexit, we have been positive about the house-building sector for some time and believe the fundamentals remain sound. The Government’s ‘Help to Buy’ scheme will run until at least 2020 while the London equivalent continues to support demand. The land market remains benign with plenty of reasonably priced land coming available. Even with the recent pick-up in activity, there remains a significant shortfall between demand (200,000+ units) and supply (140,000 units in 2015). Our preferred pick is the UK’s largest housebuilder,Barratt Developments, who have a well-diversified, regionally balanced portfolio throughout Britain. Being the largest, they have more control over build costs; and operationally, they are best in class with the lowest level of administrative costs among their peers. Barratt also plan to continue to boost output by more than 3 per cent annually, which should insulate them from any potential slowdown in house price inflation. Returns are further enhanced by management’s use of a small amount of leverage while maintaining balance sheet strength. They are also exposed to affordable homes, which looks set to deliver consistent growth well into the future.’
McGarry’s next choice is Halma.
He commented, ‘this is a conglomeration of more than 40 operating subsidiaries across four sectors (Process Safety, Infrastructure Safety, Medical and Environmental & Analysis) which has delivered 37 consecutive years of at least 5% annual dividend growth. These businesses typically occupy market-leading positions supported by regulatory and legislative drivers, as well as fundamental drivers such as increased demand for water and energy. These niche markets have significant barriers to entry and provide continued opportunities for growth and profitability. There is also a relentless focus on innovation, which allows them to participate in new/adjacent markets which leads to organic growth rates above those of their peers. The company is structured as four ‘mini Halmas’ each of which are the same size as Halma was 10 years ago. Management has said that each segment has the potential to be the same size as the group is currently. While December’s results were solid, they did not lead to the analyst upgrades that we have become accustomed to. As a result, the share price weakness that started in October has continued and the shares are now more than 20 per cent below their peak. As a result, we believe the current valuation provides an attractive entry point into a cash generative, high return company that is well placed to deliver above average organic growth coupled with value creating M&A for several years to come.
Troubled retailer Next is another of McGarry’s favourites.
He commented, ‘having increased revenues by 90% and more than tripled profits since 2002 Next announced in March 2016 that they were facing the toughest year since 2008 after a shift in UK consumer spending away from clothing towards leisure. Then in early January 2017 they released another disappointing trading update with management estimating that growth will, yet again, be negative in 2017. Taking a step back, it’s worth noting that these are not uncharted waters for Lord Wolfson who has been at Next since 1991 and CEO since 2001. They’ve been in this position before – notably 1993, 2001 and 2007 – and their response this time around will be no different. No attempts will be made to either reposition the brand or sacrifice margins to boost short revenue growth. The shares now trade on a 12-month forward earnings of 10.0x compared to an average of 16.4x in the year to January 2016. Once we factor this year’s proposed special dividend of 180p on top of the ordinary dividend, the shares are trading on a 12-month forward dividend yield of more than 8%. With the shares now down by almost 50% from the October 2015 peak this is a great opportunity to purchase an exceptionally well run, highly cash generative, shareholder friendly company at an attractive price.
Royal Dutch Shell –
Oil giant Royal Dutch Shell is McGarry’s next pick.
He commented, ‘despite the 2016 dividend being only half covered by profits, we believe that management won’t tarnish Shell’s record of having not cut its dividend since World War II. Decreases in oil production should bring the oil market into balance by mid-2017. Recently, OPEC decided to cut production by 1.2 million barrels per day, its first reduction for eight years. Russia followed suit with a 300,000 barrel reduction, while other non- OPEC countries will cut 250,000 barrels. As a result, we expect oil to be trading above US$60 by the second half of 2017. 2016 was a busy year for Shell, having acquired BG Group making them the largest liquefied natural gas company in the world, an area with attractive growth prospects. The deal also propelled the company to number one in deep water energy. The economics for these high-margin contracts continues to improve with break-even prices now below US$40 per barrel. Operationally, Shell continues to invest in new projects, which should, in time, generate significant cash. They have also said that, for every US$10 rise in the oil price, free cash flow rises by US$5bn. This means that at US$70 per barrel, the dividend would be roughly twice covered by cash flow. As the organic cash cycle improves, and the balance de-levers, we expect the market to start to accept that, not only is the dividend sustainable, but also likely to grow.
Insurance giant Saga is McGarry’s next pick.
He commented. ‘This is a UK company focused on serving the needs of the over 50s. Despite being best known for cruises, 90 per cent of profits come from their insurance business. However, this is not your standard insurance company given that they run both a home and motor insurance panel whereby third party insurers compete for new policies. This provides a platform to grow their insurance business in a capital light manner given they do not have to hold any reserves on third party policies. Saga staff perform all the customer service and claims management, allowing them to protect this well recognised and trusted brand. The cruise business currently accounts for just 3% of total profit, but this is set to increase significantly. A new ship will enter service in 2019 and there is an option for a second in 2021, with the two older ships being retired. These ships have 50% more capacity and are cheaper to run. As a result the cruise business is expected to on average deliver an uplift of £60 million, this equates to 34 per cent of last year’s pre-tax group profits. Importantly, the over 50s market is the richest, fastest growing demographic in the UK with 68 per cent of all UK household wealth. With the shares trading on 13.4 times 12-month forward earnings and a dividend yield of 4.8 per cent this is the only financial among our top picks for 2017.
Healthcare behemtoth Shire is McGarry’s next choice.
He said, ‘healthcare was the only sector in the US to generate a negative return last year. But in 2017, as concerns over tough US biotech drug pricing start to lessen, things could be about to change. Our preferred pick in this space is Shire, a leading global biotechnology company focused on serving people affected by rare diseases and highly specialised conditions. Growth has been stellar since founded 30 years ago and it hasn’t shown any signs of a slowdown, having acquired 10 companies since 2012. Shire has traditionally operated in markets with high barriers to entry with respect to both technical expertise and scale. Their drugs are usually resilient to generic competition given that their markets are relatively small compared to the exorbitant development costs of biological generic drugs. Rare disease drugs also require less sales personnel which is a significant cost saving compared to other healthcare companies. In June 2016 Shire bought Baxalta for US$32bn, its biggest acquisition to date creating the global market leader in rare diseases and other specialised disorders. We believe there is scope for greater deal synergies, which hasn’t yet been fully appreciated by the market. Management has guided towards just US$500m of synergies by the middle of 2019. However, their internal target is ‘much higher’. Were they to achieve US$1 billion which is in line with some of the major pharma mergers from recent years there would be an 8 per cent boost to 2019 earnings. Despite all of the above, the shares now trade at just 11.6 times 2017 expected earnings, which is a deep discount to its historical averages.
The final stock selected by McGarry is healthcare giant Spire.
He said, ‘after a difficult 2015, Spire is now back on-track with a number of key drivers gathering momentum. They are pursuing an aggressive organic growth strategy with new hospitals in Manchester and Nottingham to be completed in the first quarter of 2017. Now that their balance sheet leverage has been lowered, there is also some scope for acquisitions. Spire is expected to make progress in 2017 with regards to acquiring a flagship central London hospital. If successful, this should provide a significant uptick to long-term growth potential. It may also look to acquire other independent hospitals or perhaps even small regional chains over the coming years. We expect Spire to continue to deliver attractive top-line growth over the next few years in each of its end markets. Despite becoming more weighted towards lower margin NHS work, there is scope for continued margin expansion over the next few years given that half of their costs are fixed and theatre utilisation is only 65 per cent compared to Ramsay Healthcare at 80 per cent. Finally, we believe that it is only a matter of time before their largest shareholder Mediclinic makes an approach for the 70 per cent that they don’t already own. With Mediclinic’s leverage (Net debt/EBITDA) expected to fall to below 3 times this year down from 4.1 times at the end of 2014, they should soon have the financial firepower to make a bid.’