This column’s readers know I have taken a more cautious stance in the past six months, nominating gold, cash, monopoly-style assets and other defensive investments. Market uncertainty is too great to chase pricey, momentum-based growth stocks.
As written before, I see 2019 as a transition year, one where more clarity is provided on four key issues: the pace of US interest rate rises, China’s economic slowdown, whether there is a hard or soft landing in Australian property prices, and government/policy change.
The US Federal Reserve in December signalled “some further gradual” rate rises this year, so that is broadly supportive for equities if the US economy continues to perform.
But China appears to be slowing faster than markets expected, judging by this week’s growth figures. The Australian property correction is escalating and more economists are downgrading their forecasts (i.e., larger peak-to-trough price falls in Sydney and Melbourne). The downturn is hurting retailers and shopping-centre foot traffic as home owners feel less wealthy.
In politics, the odds of a Labor victory in this year’s Federal election shorten by the day and Labor will implement punitive negative gearing and franking credit policies, at precisely the wrong time, if elected. Some listed investment companies have recently rushed out special dividends to beat the franking change, assuming a Labor win.
So, three of the four issues are moving in the wrong direction for Australian shares. Do not be fooled by short-term “relief rallies”; markets are ultimately driven by earnings, and global growth is slowing. More profit downgrades are inevitable.
Use market rallies to take profits on stocks that are fully valued and reinvest into cash or other defensive investments. Cash is most valuable when nobody has it and there will be bargains later this year for cashed-up investors. This is no time to be invested fully in equities.
I do not know how these four issues will play out but I am becoming more concerned about China’s growth and the local housing downturn and its effect on consumption. The only certainty is continued higher share market volatility in 2019.
Those who want to add to stock positions should consider companies with defensive earnings streams, pricing power and reasonable valuations – companies that can maintain or steadily grow profits even if the global economy slows.
Invocare’s defensive qualities
Funeral operator Invocare (ASX Code: IVC) fits the bill. The small-cap company is Australia’s market leader in funeral homes, cemeteries and crematoria. It owns White Lady Funerals, Simplicity Funerals and Singapore Casket, operates two Chinese memorial gardens, provides pre-paid funeral insurance through Guardian Plan and has online memorial communities.
Australia’s death rate is the key driver of Invocare’s earnings. More deaths means more funerals and cremations, and higher sales. The company has a wide moat (competitive advantage) because the business of death is defensive, although not as straight forward as it seems.
Invocare has a 25% share of this market, says business forecaster IBISWorld. A newer ASX-listed rival, Propel Funeral Partners (PFP), has a 5% share. Like Invocare, Propel’s strategy is partly based on acquiring smaller competitors in the fragmented funerals industry.
The funeral, crematoria and cemeteries industry in Australia is growing slightly faster than the economy. IBISWorld predicts the $1.6-billion industry will have annualised growth of 3.2% between 2014 and 2019. Its expect the industry to earn $309 million profit in FY19.
Annual industry growth will slow to 2.5% over 2019 to 2024, tips IBISWorld. Invocare in October announced that funeral case volume for the first half of FY19 was soft and would hurt full-year profits if the trend continued.
A mild winter and effective flu-vaccine campaigns led to a 5.9% decline in Australia’s death rate in June to August compared to the previous comparative period, and possibly the same to September, said Invocare.
Longer term, medical advances, higher living standards and healthier lifestyles are expected to increase life expectancy and slow growth in the death rate. It varies year to year, but an 8% death-rate decline in some Invocare segments is unusual.
The market expects subdued growth from Invocare, a reason its total return (including dividends) is down 21% over one year. The increasing popularity of cremations over funerals is another headwind; the former costs less and has lower profit margins.
Competition from Propel Funeral Partners is another consideration. Rising competition to buy small funeral operators inevitably drives up their price. The same is true in dentistry, veterinary and other fragmented industries when ASX-listed companies grow through acquisition.
Factors supporting Invocare
I like Invocare for five reasons. First, the death rate will eventually return to its long-run average; it always does. We have roughly hovered between 6.5 to 7.5 deaths per 1,000 Australians each year since 2000. Long-term trends shows that a higher-than-average death rate in one year is often followed by a lower-than-average year, and vice versa.
If this pattern plays out as usual, Invocare should benefit from a slight uptick in the death rate in the next few years. People are living longer but that trend is hardly new and Australia, like most developed nations, has an ageing population that will maintain the death rate.
Population growth is the second driver. Invocare has a dominant position in east coast capitals, the source of most of Australia’s population growth. More people means higher absolute death volumes, even though the death rate might be steady.
Population growth plays into the third factor supporting Invocare: pressure on burial space. As capital-city densification increases, burial plots in cities will become costlier to secure. That should support Invocare’s pricing power and help overall industry growth.
This trend might also encourage a greater shift to lower-margin cremations that use less space. The decline in church attendance is another factor, because practising Christians tend to prefer funerals to cremations. Younger generations, too, might favour cremations.
Nevertheless, funeral services are fairly price insensitive. As harsh as it sounds, people who suffer grief tend not to haggle over funeral costs or shop for lower prices. Owning companies with reasonable pricing power in a slowing economy is critical.
The fourth factor supporting Invocare is acquisitions. Invocare and Propel have a combined 30% market share and the industry has 840 operators, says IBISWorld.
There is plenty of room for acquisitions and the lower death rate has seen some smaller, unprofitable operators exit the industry over the past five years. Big players could use their balance sheets to eat up more of the industry, buying weakened competitors at better prices.
Valuation is the fifth factor. At $11.65, Invocare trades on a forward price-earnings (PE) multiple of 22 times FY19 earnings. That is well above the market average of about 15, but Invocare warrants a premium given its dominant position in an attractive industry.
An average share price target of $11.68, based on the view of seven broking firms that cover Invocare, suggests the stock is fully valued. Morningstar values Invocare at $16.
I’m not nearly as bullish as Morningstar but see potential for a double-digit return from Invocare in FY19. A grossed-up yield of 5% (after franking credits) is an attraction and there is potential for a gradual share price rerating as the market realises the abnormally low death rate in 2018 is temporary.
Expectations of a modest double-digit return from Invocare might seem dull. But this type of return will look increasingly attractive if the market struggles in 2019, and it comes from a company with a wide economic moat and defensive earnings profile.
Gyrations in China’s economic growth and US interest rates will not directly affect Invocare’s earnings, although they will influence the stock indirectly through market sentiment.
Death seems a good bet as the market’s health deteriorates in 2019.
Chart 1: Invocare
Chart 2: Propel Funeral Partners
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 23 January 2019.