Business is booming.

Investors’ Chronicle: Prudential, Domino’s Pizza, Fresnillo

BUY: Prudential (PRU)

Demographics have triggered the shift into high-growth markets for the insurer with strengthening sales across Asia, ex Hong Kong, writes Mark Robinson.

Prudential is changing its focus and even its image. After the 2019 spin-off of M&G and the subsequent demerger with US-focused Jackson Life, the group is heed of demographic shifts and pivoting its attention to Asia and Africa. The Jackson deal was not without its costs. A negative fair value adjustment of $8.26bn (£6.31bn) followed in its wake, dropping down to $4.23bn once the impact of market interest rates on the value of Jackson’s product guarantees are factored into the equation.

It is not difficult to appreciate why Prudential is increasingly looking east. The group notes that although median incomes in Asia have increased markedly, an estimated 80 per cent of the population of Asia is still without insurance cover.

The estimated value of this market has been pitched at $1.8tn, although Asia is obviously not a monolith, so the group’s strategy centres on providing services based on the absolute size and demographic characteristics of each economy in the region. A bespoke offering, in other words.

Further expansion into these high-growth markets will require enhanced financial flexibility, so the group instituted a $2.4bn equity raise in Hong Kong, with the lion’s share of funds allocated towards the deleveraging of its balance sheet. One assumes that the thinking behind this move is that it is better to service debt in markets that offer higher cash returns.

And these returns, it could be argued, have been much in evidence. Eight markets in Asia and its Africa business delivered double-digit annual premium equivalent (APE) sales growth. Unfortunately, the overall return on APE sales was constrained by the ongoing closure of Hong Kong’s border with mainland China, as if we needed reminding over the issue of geopolitical risk. Nevertheless, new business sales and profit growth were particularly strong in both mainland China and Singapore, giving rise to a 13 per cent increase in new business profit.

One would hope that the ongoing difficulties being experienced in China’s property market would force a rethink in Beijing on the need to further liberalise its financial markets, as investment opportunities in the People’s Republic are simply too narrow. Too many eggs in one basket, as it were.

The dust has yet to settle on the Jackson deal, but these figures got a positive response from the market. Consensus forecasts point to a forward rating of 16 times forecast earnings, with Prudential trading at a 37 per cent discount to the combined broker target price of 1,729p.

BUY: Domino’s Pizza (DOM)

A franchisee deal and growth strategy implementation have improved Domino’s prospects, on the back of an impressive performance, writes Christopher Akers.

The future looks brighter for Domino’s Pizza after December’s resolution of the long-running dispute with franchisees over profit sharing. The full-year results buttress that good news, with revenue and pre-tax profit each climbing by more than 10 per cent and the dividend raised.

The deal with franchisees is material for the business. There will be £20mn of capital investment and new marketing investment on the company side, and a commitment on the franchisee side for more store openings — at least 45 new stores are expected over each of the next three years. Domino’s medium-term targets have been raised on the back of the deal — over 200 new stores and system sales approaching £1.9bn are now considered achievable.

The other part of the story here is the new growth strategy that was unveiled last March. This is based around five “growth pillars”, including delivery — a new app was launched in the year — and driving efficiencies in supply chains. The strategy is paying dividends, literally and metaphorically. The company generated over £100mn of free cash flow in the year, has raised the full-year dividend, invested £14mn in capital projects, and announced a new £46mn share buyback programme on top of the £80mn completed in the year.

Numis analysts said of the company that “investors overlook how defensive its earnings are”. The shares are trading on a consensus 17 times forward earnings, which looks undervalued given a solid year and growth prospects. It has been a topsy-turvy couple of months for the dough-roller’s shares, but we think it’s time for an upgrade.

HOLD: Fresnillo (FRES)

The silver and gold miner will get boost from higher prices but new labour laws and permitting issues could hit 2022 production, writes Alex Hamer.

On paper, global turmoil means higher profits for silver and gold miner Fresnillo. But operational challenges and a new Mexican labour law mandating workers are full-time employees mean the miner saw a decrease in gold production and flat silver production compared with last year. 

Its dividend did hit a four-year high, however, and management said it expects higher precious metals prices to support earnings this year after a “realistic floor” was established in 2021. Gold was trading around $2,000 (£1,527) an ounce (oz) this week, while silver is up just over 10 per cent since the start of February, to almost $26 an oz. 

Fresnillo has maintained its 2022 production guidance but was extremely cautious in its results announcement. “Inflationary pressures, the impacts of various laws and the attitude of the government in Mexico to mining all have the potential to influence our progress,” said chief executive Octavio Alvídrez. 

Costs were up for other reasons last year. Fresnillo’s key silver mine, Saucito, saw its cost of ore milled climb a quarter to $89.8 a tonne. The biggest contributor to sales, the Herradura gold mine, saw its costs climb almost a fifth. The Mexican peso falling in value was a significant part of these hikes, while at Saucito two floods also had an impact on costs. 

Fresnillo said new labour laws prohibiting outsourcing had meant tough adjustments on the ground. “Subsequent contractor uptake [post September 1, when the law came in] has varied, with underground mines more affected resulting in an increased number of vacancies and a higher workforce turnover,” the company said, adding a recruitment drive was in place to bring in more permanent workers.

There is also uncertainty about when a new mine, Juanicipio, will be in production after being completed at the end of 2021 because the government has not approved its connection to the national power grid. Fresnillo has pushed back the mill commissioning timeline six months, which broker Peel Hunt said would likely see power coming on mid-year. Juanicipio will eventually produce 11mn oz of silver a year, a fifth of 2021 silver production. 

Peel Hunt forecasts a 9 per cent drop in cash profit this year, to $1.3bn, although at a stable margin of 53 per cent. 

This will probably be a tougher year than anticipated for Fresnillo, which has now lost most of its pandemic-era gains although is in a net cash position and has finished with a heavy capex period.

Chris Dillow: Deciphering mixed messages on US equities

There’s a danger that the fall in US equities this year could turn into something very nasty, because when overvalued markets start to fall they can drop a lot. When the tech bubble burst in 2000 for example, the S&P 500 lost more than 40 per cent.

We do, though, have two warning signs that can help us avoid such losses.

One is whether the index is below its 10-month (or 200-day) moving average. Mebane Faber at Cambria Investment Management has shown that a rule of selling when the S&P is below this average would over the long-run have given better risk-adjusted returns over the long run than a simple buy-and-hold strategy.

Of course, the rule doesn’t always work so well. It told us to get out in March 2020 after the start of the pandemic had clobbered global markets, for example. We would therefore have missed out on the start of a big bounce back.

This is a general problem with the rule. Although it does a great job of protecting us from long bear markets it fails when a strategy of buying on dips works. It fails when the market is dominated by value investors (those who buy on dips), but works when it is dominated by momentum investors — those who sell because others have sold.

As I write, the rule tells us to sell US stocks.

It, however, is not the only lead indicator of returns we have. There’s another: the shape of the yield, which I’ll define as the gap between 10-year Treasury yields and the Fed funds rate. Inverted yield curves in 2000 and 2007, for example, both led to big falls, while the bull market of 2009-19 followed mostly upward-sloping curves.

The curve is telling us to stay in equities, contradicting the message of the 10-month rule.

But this rule, like the 10-month rule, isn’t perfect. It told us to get out of equities in 2006 and early 2020, which would have meant missing out on months of nice gains, and to get into the market in mid-2008 before some heavy losses.

So which rule do we believe? The answer is: both. A combination of the two has worked better than either in isolation.

We can quantify this. Since 1990 US equities have risen by an average of 10 per cent in real terms in the 12 months after both the 10-month rule and yield curve told us to buy. But it has fallen by an average of 6.8 per cent in the 12 months after both told us to sell. When the 10-month rule told us to buy but the yield curve to sell, the market has dropped by an average of 2.6 per cent. And when the yield curve has told us to buy but the 10-month rule to sell the market has risen by an average of 5.8 per cent.

With the latter being the message now, investors therefore have reason for hope. Except, that is, for two things.

One is that there is variation about this average. Sometimes the 10-month sell signal has been correct while the yield curve buy signal has been wrong: this was the case in 2008, for example. Even with the best lead indicators we cannot time the market perfectly, any more than we can pick stocks perfectly.

The other is that we’ve reason to doubt the message of the yield curve now. It has worked well in the past because it has embodied the wisdom of crowds. Each investor has a little dispersed and fragmentary insight into where interest rates and the economy are heading. The yield curve aggregates together all these insights such that when 10-year yields are below short-term rates it really is a predictor of recession. The whole is much greater than the parts.

Now, though, the main determinant of where the market is heading lies in the mind of Vladimir Putin.

Personally, I am cautious about the market: I have around a 50 per cent cash weighting. Such caution might be mistaken. But I’d much rather be wrong in this direction than the other.

Chris Dillow is an economics commentator for Investors’ Chronicle

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