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Investors’ Chronicle: Unite, Hargreaves Lansdown, Rio Tinto

BUY: Unite (UTG)

The student landlord expects occupancy to return to 97 per cent next year, near pre-pandemic levels, writes Madeleine Taylor.

Students are returning to the UK’s universities en masse, with applications for the 2022/23 academic year 7 per cent higher than their pre-pandemic levels, spelling good news for student landlord Unite. The purpose-built housing firm’s shares reversed their downward trajectory this year, with a 7 per cent jump on results day.

Occupancy of Unite’s 70,000 beds across England, Wales, and Scotland has recovered to 94 per cent from 88 per cent in the previous academic year, when the pandemic’s disruption of face-to-face teaching left beds unoccupied and rents discounted.

While current occupancy rates are 11 percentage points higher than industry peers, they still lag behind pre-pandemic levels of 98 per cent. This was mostly down to distortions in the student housing market, caused by lower numbers of Chinese and European students, as well as grade inflation, which left more UK students able to attend their first choice university and changed the distribution of students across cities and towns.

These conditions look likely to ease up. The government has promised to bring grade boundaries back down to earth over the next two years, and record high numbers of UK school leavers entering university may help make up for the international shortfall, which typically accounts for 30 per cent of the company’s customers.

Two-thirds of Unite’s rooms are already reserved for the coming year, and the housing firm predicts occupancy will reach 97 per cent in the next year, with average rent increases of 3.5 per cent.

Miranda Cockburn at Panmure Gordon said shares are trading at a 12 per cent premium to the reported net asset value, which “looks good value” given the landlord’s ambitious £967mn development pipeline. Three-quarters of this will be spent on extra beds in London, and with a 6.2 per cent yield on cost, the broker says this could add 10p to earnings per share.

This is hard to argue with. Unite has positioned itself well to take advantage of fast growth in the student population, while its agreements with universities covering half of its beds lends some stability to demand.

HOLD: Hargreaves Lansdown (HL.)

Hargreaves Lansdown’s shares face double-digit losses on the announcement of falling profits and plans for a digital hybrid advice service, writes Mary McDougall.

The platform industry’s juggernaut Hargreaves Lansdown’s shares plunged on results day, as profits dipped and the firm announced a five-year £175mn spending spree to give its service a digital makeover as it feels the heat from rising competition.

This feels like quite a harsh reaction for a company that increased its market share to 43.3 per cent and welcomed 48,000 new clients to the business over the six months to the end of 2021, with assets under management rising 4 per cent over the period. But the question lingers over how long Hargreaves’ dominance can last as newer, cheaper rivals start to gain prominence.

While revenue margin from shares fell from 0.56 per cent to 0.37 per cent, share dealing volumes were 83 per cent higher than in the same period in 2019. Funds revenue, meanwhile, increased by 21 per cent, with its revenue margin broadly in line with historic averages.

Hargreaves’s profits will take a hit over the next five years as it rolls out its new strategy, but it’s probably the right thing to do for the long-term health of the firm. The company hopes to “redefine wealth management” by encroaching more into the savings and advice market to deliver a personalised way to manage savings. As chief executive Chris Hill put it at the company’s capital markets day, the plan is to achieve this by “automating the hell out of everything”.

The sacrifice for shareholders is that the special dividend has been suspended until its 2024 financial year, although the board has declared an ordinary half-year dividend of 12.26p per share, up 3 per cent on last year. Numis forecasts that the dividend yield will stay above 3 per cent over the next three years.

The company’s growth targets are ambitious. Chief executive Chris Hill expects 2.1mn customers by its 2024 financial year end, up from 1.7mn today. The company, which had assets under management of £139bn at the end of December, estimates that its total addressable market (including cash) is £3tn growing to £4tn by 2026, partly owing to a structural shift away from defined benefit pensions.

Client retention has stayed high at 92.7 per cent following a flood of new customers in 2020. This could prove harder to maintain if the industry sorts itself out and makes transferring to cheaper options easier, but there’s currently little sign of this changing.

A forward price/earnings ratio of 22 times, according to FactSet, is still a premium to the industry average, but well down on the five-year average of 30 times as the share price has dropped by over a quarter over the past 12 months. Sentiment is clearly negative on the company, but Peel Hunt has it on a buy rating with a target price of £18.35. Time will tell if its reinvention pays off.

HOLD: Rio Tinto (RIO)

A special dividend is to come as free cash doubles on 2020 as copper, aluminium and iron ore prices send earnings soaring, writes Alex Hamer.

A bruising recent few months that left Rio Tinto faced with yet more challenges, including fixing a toxic internal environment and rescuing the cancelled Jadar lithium project in Serbia, has still ended with record profits and dividends, thanks to the strength of global commodities prices.

The major miner has joined BHP and Antofagasta in offering shareholders even more than forecast, with a final dividend of 417¢ (307p) and a special payout of 62¢, which was slightly ahead of company-compiled consensus analyst estimates.

Chief executive Jakob Stausholm said the company had been able to “capture” the global economic recovery, driving the surge in profits. Rio hit free cash flow of $17.7bn, up 90 per cent on 2020. That was achieved even with capital expenditure climbing. The company has now moved back to a net cash position, although the dividend payments will soon see it return to net debt status. The iron ore division led the way as usual, registering a 46 per cent increase in underlying cash profit to $27.6bn, while the smaller aluminium and copper units saw a doubling in underlying cash profits on stronger prices.

Headwinds were evident in Rio’s cost guidance for 2022, however. The miner sees the Pilbara iron ore cash cost climbing from $18.60 a tonne in 2021 to $19.50-$21 a tonne this year, while copper costs will surge from 82¢ per pound (lb) to 130¢-150¢. 

This month, the miner promised major reforms to its working culture after a report found widespread misogyny, racism and bullying within its ranks. Rio boss Stausholm told analysts that the company was becoming “less hierarchical” in response and would focus on “empowering” workers. He also used the 2021 results presentation to outline an update to the company’s carbon emission reduction plan, which includes a 15 per cent cut to operational emissions within three years.

This is certainly a high point for the mining industry and Rio, with earnings and payouts forecast to come down this year as costs bite. Questions over Rio’s expansion options make us prefer BHP in the long term.

Chris Dillow: The welcome bond sell-off

There has been much alarm about the sell-off in US bonds: since the start of the year, two-year Treasury yields have risen from under 0.8 per cent to just under 1.5 per cent, and 10-year yields from under 1.6 per cent to almost 2 per cent. For equity investors, such alarm is misplaced. These are in fact welcome developments.

History tells us that the higher bond yields are relative to the fed funds rate, the better equity returns tend to be thereafter. Since 1990 the correlation between the gap between two-year yields and the fed funds rate and subsequent three-yearly changes in the S&P 500 has been 0.4. The 10-year/two-year gap and 10-year/Fed funds gap have also both been significantly positively correlated with subsequent returns.

The effect here is big. Since 1990, each one percentage point greater gap between two-year yields and the fed funds rate has been associated with 25 percentage points higher equity returns over the following three years.

By contrast, inflation has no predictive power for returns. Since 1990, the correlation between annual CPI inflation and S&P 500 returns in the following three years has been an insignificant minus 0.11. Higher inflation therefore tells us nothing about future equity returns, but higher bond yields do.

This ability of bond yields to predict equity returns is especially strong if we look simply at whether the yield curve is upward-sloping (with long-dated yields above short-dated ones) or not.

Since 1990, the S&P 500 has risen by an average of 36.1 per cent in the three years after two-year yields have been above the fed funds rate, but by only 8 per cent after they have been below it. And it has risen by an average of 36.3 per cent in the three years after 10-year yields have been above two-year ones, but fallen by an average of 23.7 per cent after they have been below them.

For example, 10-year yields fell below two-year ones in 2000 and 2006, and on both occasions equities fell sharply in the following three years. But the 2009-2012 upturn and the recent bull market both followed 10-year yields being above two-year ones.

History therefore tells us that the rise in two-year yields relative to the fed funds rate is good news, as it predicts better equity returns. What is concerning is that two-year yields have also risen relative to 10-year ones. But with the latter still above the former, the outlook for equities is OK.

There’s a simple reason for this. Bond yields should be equal to the expected path of short-term interest rates: if yields are higher than the fed funds rate it is a sign that markets expect the funds rate to rise, and if they are lower than the funds rate it is a sign they expect it to fall. Bond yields have risen recently because markets have revised up their expectations for short-term rates.

And there is wisdom in crowds: these expectations are often correct.

But what are the circumstances in which short-term rates rise? Ones in which the economy is doing well and shares are rising: the Fed would not raise rates if it were otherwise. By contrast, a world of falling rates is one of a weak economy and falling share prices.

If you want to know the chances of recession you should look at the shape of the yield curve and nothing else.

This is why the sell-off in bonds is a good thing from an equity investor’s point of view. It is a sign that interest rates are expected to rise. But this will only happen if the economy and stock market are strong.

You can be forgiven for thinking this is weird. Efficient market theory — and indeed common sense — tells us that obvious information such as the level of bond yields should be immediately embedded into share prices and so have no ability to predict them. But they clearly have had lots of ability to do so.

This could be because investors have in the past paid too much attention to the bad news of rising interest rates (a higher cost of capital) and not enough to the good — the fact that rates rise when the economy is strong.

Which brings us to a perennial danger with inferring the future from the past. It’s always possible that investors have learned from their past mistakes and in wising up have eliminated predictability. Now, in this case there is no evidence this has happened. Quite the opposite. The fact that equities have fallen during this bond sell-off is consistent with investors focusing upon the bad news of forthcoming rate rises and not the good. But we cannot rule out with complete confidence the possibility that the historic ability of yield curves to predict returns has disappeared.

What we can say, though, is that insofar as history is a guide the sell-off in bonds — and especially the rise in two-year yields relative to the fed funds rate — augurs well for shares. What we have to fear is not that bond yields have risen, but that past relationships have ceased to be a guide to the future.

Chris Dillow is an economics commentator for Investors’ Chronicle

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