A2 Milk Soars: Time to Get Defensive?

Basketball is a game I love watching. It’s fast, furious and at times frustrating.

My son plays in a local school team. Every week you see raw emotion on the court. Typically, if they get off to a good start and notch up the first points, they go on to play well. If they start on a losing streak, confidence gets shattered and it can be downhill from there. At one point, things looked so bad they started playing the wrong direction.

A good basketballer knows how to play both defence and offence.

And it’s the same in the market.

In a high market, especially, you look at defensive stocks which can maintain return and see you through a downturn.

Otherwise you might be looking at some more offensive growth-type stocks to juice your capital.

The a2 Milk Company [NZX:ATM] has been a fabulous ‘offence’ stock over the past 5 years. Just the other week, it surged again near its all-time high of over $17.50.

Four years ago, the share was under $1.

Commercialising a1-protein-free milk has been a great growth story. It’s ripped down the basketball court and slam-dunked year after year!

And those who’ve been on-board deserve their profits. They took the growth risk. They banked on a2 milk gaining traction in the global markets — and it has, especially in China.

But a2 Milk is a bit like one of the key attackers in my son’s basketball team. He’s an aggressive show boy and one-trick pony. He’ll run the court and slam dunk. But he may not always wait around and defend key zones of the court.

So a2 Milk hasn’t paid a dividend. You must sell down to release any of the cash gain. And it would seem to me that their high-growth days might be behind them.

Most of the earnings come from China. Right now, China is on the US’s hit list (and others) as an export-thumping economic adversary. So a2 shareholders should be nervous of any deep slowdown in China.

That’s not to say a2 Milk won’t enjoy more growth. They’re only scratching the surface of the opportunity. And the business is showing strong returns on equity, strong returns on assets and superior margins.

In a high market, though, it’s vulnerable. If there’s any panic on the lofty NZX, high-riders like a2 could be in for a sell off.  And make no bones about it, a2 is an expensive stock. P/E sits around 50 and book-value per share less than $1.

But it’s expensive because it makes good money on its capital. Those earnings must keep increasing or the stock price might run out of fuel. And that depends on your summation of the a2 opportunity worldwide — which is not without risk.

So where do you look for defensive stocks?

One of the first tests I run is the ability for the company to maintain revenue. And continue paying dividends during an economic meltdown.

This way, you could potentially hold some value and earn a return on your capital (via the dividends) — while the rest of the market crumbles.

For example, take a look at how McDonald’s Corp [NYSE:MCD] fared during the GFC when other stocks fell 40% or more:

During 2008-10, it held most of its value. Then it started to take off again afterward. Meanwhile, it shared profits as a steady dividend.

When times get tough, a cheeseburger looks pretty good value.

Property-based stocks can also be quite useful in this area. Particularly those that focus on specialist areas not as prone to downturn, such as childcare centres or farms.

Specialist resources stocks are also of interest. And I’ve found one which might provide value and upside no matter what the rest of the market may do.

Of course, this sector is not entirely defensive. Since a global crash can mean demand for resources falls away. But certain specialist areas providing minerals for products like household paint could always be in demand.

Further, these stocks are a little more volatile than your other defensives like McDonald’s.

That means there are often dips outside of wider market sentiment in which you can buy well. For example, the stock I’m watching fell heavily due to temporary production forecasts not met. This is probably an overreaction and provides a buying opportunity.

Besides, selected resources stocks tend to have strong cash flow with excellent return on capital and margins. And dividend yields can be strong.

Watch out Wednesday…

This Wednesday, I plan to launch our new newsletter — Lifetime Wealth Investor.  This will cover my current resources and defensive stock picks.  With specific recommendations here.

Meanwhile, in your investing, consider your appetite for offence and defence. 

And how the current market might reward either strategy…

Regards,

Simon Angelo

Editor, Money Morning New Zealand­­­­

Important disclosures

Simon Angelo owns shares in McDonald’s Corp [NYSE:MCD] via wealth manager Vistafolio.


Simon is the editor of Wealth Morning and has been investing in the markets since he was 17. He recently spent a couple of years working in the hedge fund industry in Europe. Before this he owned an award-winning professional services business and online learning company in Auckland for 20 years. He has completed the Certificate in Discretionary Investment Management from the Personal Finance Society (UK), has written a bestselling book and manages global share portfolios.


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