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Stock of the week: a2 Milk

One of the most well-known stocks in the New Zealand market is the dairy company, a2 Milk. Their business? They sell milk of the a2 kind (not kidding) and sell related milk formulas such as infant formula and milk powders.

Why is it called a2 milk? Well, I’m not a milk expert. However, from my understanding, A2 corresponds to the main protein based in the milk of the respective cow it comes from. A2 Milk, not surprisingly, sells milk-related products from cows who produce milk with the A2 protein in it. This is because they initially claimed that milk with A1 proteins in it have health disadvantages. However, the European Food Safety Authority reviewed that the scientific evidence and concluded that this is untrue and that both A1 and A2 proteins harm health.

a2 Milk stock price

a2 Milk’s Catalyst:

In the past, A2 Milk’s largest competitors were… its customers.

In 2008, the infamous China Milk Scandal, where milk and milk-related formula (notably, infant formula) were having melamine added to it to pass quality control testing, gave it a higher protein content. There where over 300,000 victims and six babies died from kidney stones. Since then, the trust of milk-related products from China has plummeted, and imports from other countries in China skyrocketed.

A2 milk did not offer its products to China directly until very recently. Therefore “daigou” (Cross border exporting) of the product from New Zealand to China were very prevalent, often charging 50-100% markup on the cost here in New Zealand. This forced supermarkets in New Zealand to restrict the purchase of infant formula to 4 per person at the time.

However, A2 milk has strengthened its foothold in China and has stated that its disruption to the daigou market has started to appear in earnings reports. Furthermore, the Coronavirus has been a tailwind for the company, as the daigou has all but dried up due to travel restrictions.

a2 milk’s Risks:

Many sellers have been attacking the company as of late, especially at its peak around August, when its price to earning’s ratio was above 40, requiring the company to release earnings nothing short of perfection to justify the valuation. However, earnings were down around 6.4%, causing a 29% drop in the stock price.

The risk is that it still trades at a premium, around 30 times earnings. This is relatively high, considering Tech stocks like Apple, Facebook, Google, etc. change around 33 times. A2 Milk at a tech stock valuation, when they are set to see declines in the next couple of quarters?

a2 milk Conclusion:

a2 milk has had a legendary run, one of the best in the NZX. From 2017 to its peak in August this year, the stock has returned an outstanding 833% for shareholders. However, it has traded at a premium for a long time. There is no tolerance for lackluster returns in a fundamentally weak global environment, and a2 milk shows that. This may be a stock that you should keep on your watchlist and wait until global conditions get better before entering this high flying stock position.

Ballast for the common stock portfolio - Bonds, Gold, or the USD?

A common portfolio weighting known amongst many investors is the 60% stocks, 40% bonds portfolio. The general idea being that stocks appreciate in a bull market, while bonds keep their value in a bull market. Therefore, if you were long 40% bonds, you would have somewhat had a ballast for the drop in stock price. As of late, however, we have been associating the words “safe haven” and phrases such as “investors flee to safety” with assets such as Gold and the US Dollar. Have bonds lost its relevance as ballast in a modern investor portfolio?

Does a low-interest-rate environment diminish the ballast effect of bonds?

Recession Fed Funds Rate
2020 – COVID 19 Pandemic (Feb – Present) 0.25%
2008 – Global Financial Crisis (Dec 2007 – June 2009) 0.25%
2001 – Dot com bubble (Mar 2001 – Nov 2001) 2.5%
1990-91 – Savings and Loan crisis (Jul 1990 – March 1991) 6.25%

The current fed funds rate is 0.25% - currently matching the lowest, it has ever been a post-global financial crisis in 2008. Recessions before that, however, had the Federal Reserve cutting rates to nothing as low as it is now or during the Global Financial Crisis. 

In short, pre mid-1990’s was where the strong negative correlation between stock and bond returns became evident. This was on the basis that accommodative monetary policy would bring interest rates lower, increasing the opportunity cost in owning bonds as opposed to leaving cash in a savings account. However, if you look at the table above, both in 1991 and 2001, interest rates were high enough for a real yield if you held government treasuries. But in our current environment and 2008? Real yielding safe government treasuries could not be achieved. Therefore, the opportunity cost does not spark as much interest in investors as they did back pre 2000’s, where high single-digit and even double-digit interest rates were present. 

Is having Gold as a Ballast currently paying off?

Performance of the US 10 Year in blue, SP500 in red, Gold in orange and the US Dollar in Teal

As shown by the chart, Gold has returned around 12% year to date, while treasuries have only returned 8%. You can see the markets working in reaction to economic events such as treasuries rising in March as the FED cuts rates and the real damage of the coronavirus pandemic becomes clearer. Furthermore, the inverse correlation between the USD and the price of Gold is present in the chart, with the exception being around mid to late March – where quantitative easing and fiscal spending give rise to concerns to the devaluation of the dollar. As we look into April and May, it is clear that Gold is currently outperforming treasuries, which would be more beneficial as ballast in comparison to Bonds in these circumstances. However, both are outperforming the US Dollar.

Is Gold a better ballast than Bonds in these low-interest-rate environments?

There is a likelihood that Gold will outperform Treasuries in this low-interest-rate environment. Given fiscal and quantitative easing alongside the demand for other currencies slowly increasing, it is likely we see the USD lower at the end of the year than at the start of the year. If the historical negative correlation between Gold and the USD rings true, there is also a high chance that Gold will end up higher at the end of the year.

Interest rates can only go so low. If the Federal Reserve lowers rates into negative territory, New debt issuance by the US Government will be hovering at nominal yields near 0% - with real yields most definitely being in the negative territory. This gives an implicit ceiling as to how high bond appreciation can go. Given a possibility for a second wave, risky assets may still be off the table for many investors. With Bonds providing next to 0% yields, investors may seek to look towards Gold as a source of capital growth instead of yield.

Our analysts here at BlackBull Markets, Philip and Anish,  have some excellent technical analysis on the future of Gold and the USD as the safe havens of the world. You can watch the Philips' Gold analysis here, and Anish's analysis here.