Dollar earners – one sector to buy, and one to avoid
The defining trait of the immediate post-Referendum market, has been the division of UK equities into Brexit “winners” and “losers”; domestic names shunned and dollar earners bid higher. The repricing of sterling in the aftermath of the vote was indeed significant: from its pre-result level of $1.50 on 24 June, sterling has tumbled 14% to its recent low of $1.29 on 7 July.
We view sterling as likely to remain soft over the rest of the year, with Cable potentially settling closer to $1.25/£. We therefore see the attraction of increasing exposure to overseas earners, whilst maintaining our longstanding exposure to US quoted companies at a steady 20% weighting.
While this view is relatively commonplace amongst pundits, we differ to the extent that we think investors should be very selective. It is critical that investors identify businesses with strong macro-thematic tailwinds, rather than simply screening for US dollar earnings and buying those stocks with the greatest exposure.
We highlight the dangers of the latter approach by contrasting the prospects of two sectors which have rallied due to their high US dollar earnings: Oil & Gas and Pharmaceuticals.
As income investors with a long-term time horizon, one of our key investment criteria is surety of income; dividend sustainability and growth is preferred to the allure of high nominal yields. With oil trading under $50/barrel, the Oil & Gas sector fails this test.
The level varies between companies, but in broad terms the oil majors require an oil price of $50-$60/barrel to maintain current dividend payouts, capex commitments and high levels of gearing. Below this level, cash flow is insufficient to support, let alone progress dividends and alternative sources of funding are required. The upshot is a hand-to-mouth dividend policy funded by asset sales.
The broker Redburn estimates that global oil majors need to raise $50bn to fund shortfalls on dividend cover. While such asset disposals help the oil majors fund near-term dividend shortfalls, they necessarily impair future cashflow potential and undermine their ability to sustain dividend pay-outs. There is an obvious limit to this process, particularly when the majority of oil majors are selling assets and buyers form a minority. It seems reasonable to ask, where exactly are the buyers?
The oil majors will not be bailed out by OPEC. As OPEC’s monopolistic power has waned in the face of non-member production, so too has its ability to keep their house in order. With too many of its members now likely to renege on any agreement to restrict production, an output freeze has so far proven elusive.
The Oil & Gas sector’s recent gains (+18.5% since 1 June) therefore appear to have fully priced in the Brexit benefit of a translation uplift on dollar earnings, but fail to reflect the longer-term costs of weaker spot prices. The industry’s obvious gearing to the economic cycle bodes ill, particularly in light of post-Brexit uncertainties and gathering downgrades to global growth forecasts. July’s quarterly earnings disappointed, underlining the sector’s negative operational leverage to a low oil price.
Oil’s longer-term sector outlook is clouded by the growing viability of alternative energy sources, a trend which is increasingly visible through the transformation of electric cars from expensive and inefficient curiosity to the verge of mass-market penetration. Even the Saudis appear to know the fossil fuels game is up; the recent ‘Vision 2030’ agenda outlining a strategy to boost non-oil revenues in the wake of lower for longer spot prices.
We have reduced Oil & Gas exposure over the last 12 months (selling BP entirely and allowing Shell’s takeover of BG Group to dilute our sector exposure), and we are now in the process of reducing our final sector holding in Royal Dutch Shell, using the dollar strength – and resultant share price rally – to exit this sector at full valuations.
In stark contrast, Pharmaceuticals – another sector which has rallied post-referendum to reflect its international earnings profile – also benefits from powerful macro-thematic tailwinds.
These underpin growth in earnings and dividends, as illustrated by consensus-beating results last week from both AstraZeneca and GlaxoSmithKline.
The demographic necessity for increased global healthcare spending is clear, and there has been a recent reappraisal of the sector’s role in tackling high-profile outbreaks of communicable and infectious diseases in a globalised world – Zika being the latest. It seems that global health is now an issue which will increasingly attract international sources of finance, such as the Pandemic Emergency Financing Facility (World Bank and World Health Organisation).
So while the Oil & Gas sector’s hand-to-mouth approach of maintaining dividend pay-outs is contributing to a deterioration of its long-term prospects, the Pharmaceuticals sector looks primed for earnings growth which will underpin dividend progression. We are happy owning all the UK pharma large-caps (AstraZeneca, GlaxoSmithKline and Shire), with any lingering investor concern over GlaxoSmithKline’s dividend cover now swept away by a combination of sterling weakness and unexpected strength in sales of its HIV and respiratory treatments.
Stephen Bailey, manager of the Liontrust Macro Equity Income Fund