Sun Herald: A strange year for Aussie equities

AFR Investor, Sun-Herald/Sunday Age, November 2010

It has been an odd year for Australian equities: plenty of sound and fury, debate and conjecture, only to end up pretty much where they started. At the time of writing, the S&P/ASX200’s performance was down 4.6% since the start of the year, confounding both the optimists and the bears.

“What’s got us here?” asks Ric Spooner, market strategist at CMC Markets. “It’s been a bit of a compromise – just like the first Grand Final, a draw.” 12 months ago, he says, there was “a pretty strong V-shaped recovery camp at the bullish end of the spectrum.” This group believed that the bounceback shown by equity markets in 2009, in Australia and worldwide, would be replicated in 2010 and that the future was bright. “That view has thus far proven incorrect.”

But on the other side was the bearish view: that all we saw in 2009 was a bounce completely out of step with reality, and that with the spur of sovereign debt defaults in Europe and potential further bank collapses, markets would sink right back down again. “That hasn’t happened either,” says Spooner. “The worst fears haven’t come to pass.”

The result is a market that has demonstrated no clear trend and is difficult to call. “We are living in a post-GFC environment and the markets remain fairly volatile,” says Anton Tagliaferro at Investors Mutual. “We would expect this to continue for some time.”

SUBHEAD: BEWARE THE US

Different parts of the world have had markedly different experiences since the financial crisis, and the performance of Australian stocks has partly depended on what they are exposed to. As a rule of thumb, stocks exposed to emerging markets have done well, whereas those exposed to the US have fared badly. Simon Burge, chief investment officer at Above The Index Asset Management, notes that one of the best portfolio decisions his fund made this year, alongside all the successful commodities picks, was one that the fund didn’t hold: Westfield. “It’s a big stock in the market but is reliant on the US recovery, and that hasn’t happened,” he says. Numerous Australian companies are impacted by this, partly because of broker opinion. “Aussie analysts say: the US recovery is no longer going to be second half 2010, it’s going to be first half 2011, and so on – they keep pushing the numbers out. So markets have run ahead of themselves: a lot of stocks have been pricing in an earnings profile that possibly won’t be there.”

The US will of course recover at some point. “People may ring up and say they want to take money out of Australian dollar investments and into international because they think it’s going to go berserk,” says Burge. “And they’re right: at some point that’s going to happen. But it certainly doesn’t look imminent.” For him, therefore, the way to go continues to be resources: his portfolio has been driven by obvious bulks like BHP Billiton and Rio Tinto, and also more specific plays like Equinox (copper), Mt Gibson (iron ore) and nickel. For Burge, commodity plays have been so good they have disguised the weak health of the rest of the economy. “Australia has an insulated economy,” he says. “You’ve got the resources boom providing amount amounts of GDP, tax and so on, but Australian retailers are experiencing price deflation. People are not buying and wealth is not shared across all of the sectors. There are lots of parts of the economy that are not firing.”

SUBHEAD: RESOURCES WARNING SIGNS

Frank Villante, of Celeste Funds Management, also notes this exceptional performance of resource stocks but is more troubled by what it signifies. A small caps specialist, he notes that the Small Ords index is up 11.47% in the year to the end of October, but within that small resources stocks are up 29.1% and industrials only 1.94%. “The concern is in the last few months the interest has migrated from emerging producers who have resources – who have delineated assets, cashflows and production – to further out plays like rare earth companies that may be cash generative at some point in the future. It’s much more bubbly.”

For Villante, there’s no reason to worry about the broader market; “in totality, in terms of earnings and yield, it doesn’t look that bad,” he says. And he has no alarm about BHP or Rio, beyond volatility based on perceptions of iron ore and coal pricing. “But there are certain pockets of the market which have characteristics of bubble about them. Bubbles can continue for a long time, and companies without fundamentals can be valued at millions or billions of dollars. But inevitably, they do what all bubbles do.”

Concern about resources is becoming more widespread. “I think one has to be very careful of the commodities trend,” says Tagliaferro. “It’s beginning to smell like a bubble, in view of the number of hedge funds going long commodities and the way speculative stocks are booming again – that’s always a warning sign. That’s not to say it can’t go on a bit longer, but it looks absolutely crazy when you look at the market caps of some of the smaller resource companies.”

SUBHEAD: BORING IS GOOD

Resources froth may be disguising better opportunities, Villante says. “The parts of the market with established businesses, good balance sheet and cash flows paying attractive yields – that’s almost a bit forgotten,” says Villante. “Some more dull, boring bits of the market may become fashionable over the next 3, 6, 12 months as people say: yes, it might be nice to own [Western Australian rare earths producer] Lynas Corporation, because it might be cash generative in 2018 and pay a dividend in 2025, but in the meantime I can find big industrials paying me 4.5 to 5% fully franked, which is not that unappealing, particularly in an environment where global growth will probably end up at a norm of 1 to 2% a year.”

He adds: “Over the next six to 12 months, I think you get paid for being quite conservative and looking towards businesses with established operating assets that are cash generative, that have balance sheets, have good interest coverage, and are not spurious or conceptual or nature. Boring businesses that spit out dividends: ANZ, CBA, IAG, QBE, Foster’s Group.”

Tagliaferro has a similar conclusion. He’s not especially impressed with prospects for the broader market. “Investor confidence is pretty good, and whilst stocks don’t look overly expensive, the issue is that earnings growth in the year ahead is going to be fairly subdued,” he says. “That’s the key. It’s hard to see a massive rerating.”So instead one must find value elsewhere, and like Villante, Tagliaferro finds it in traditionally rather boring places. “There is value in stocks like Metcash, Dulux and CSL, but you’ve got to be more stock specific – it’s a stock picker’s market,” he says. “Overall, the market is going to trend sideways for a while so it’s a question of finding stocks that can grow in a lacklustre environment.”

Others do see better prospects in the broader market. Spooner points out that, although the actual value of the index is much the same as a year ago, it is stronger – because valuations are more reasonable. Forward price-earnings ratios are typically in the region of 12.5 to 13.5 now, compared to 16 or 17 a year ago. “Whilst price levels are the same, valuations are sounder now,” he says. Logically, that means the outlook is better now than it was a year ago. “The most likely scenario is a reasonably optimistic one for share market investors: that is, that we will see reasonable growth in the Australian economy, and reasonable earnings growth. That earnings growth will be enough to see a total return of 11 or 12% – dividends plus growth – and the risk is to the upside there, I think.” If attitudes to risk soften a bit, he says, it could be more like 15 to 20%.

But Spooner spots some other troubling trends that could undermine price performance. “One thing that sticks out in the last 12 months is that we have seen real evidence of what could well be a lasting, medium-term change in consumer behaviour,” he says. “The increase in savings rates that has occurred in the developed world has proved itself to be more than a temporary cyclical phenomenon.” In short, people are saving more, spending less.

SUBHEAD: DO WE WANT RISK?

Managers seem to vary in their views on attitudes to risk. While Spooner says “risk premia remain relatively high and risk tolerance is lower than it has been,” Villante disagrees. “Over the last few months, in the post-GFC mindset people have been prepared to move further out on the risk spectrum in anticipation of the global economy growing at a reasonable clip and hoping that emerging market demand will fill in a lot of the gaps in terms of domestic demand,” he says. “The greatest thing over the last 12 months was post-GFC stabilization: the economic system as we know it continues to exist. But then investors got a little bit too much religion.” In particular, he notes “the expectation that China and India will drag Australia through any issue that may emerge. And in recent weeks, the default rebuttal to any argument that highlights risk or concern has been some reference to quantitative easing, as if that means everything will be fine.”

While Tagliaferro plumps for isolated pockets of value, Villante for dull industrials and Burge for commodities, Spooner thinks one key theme for the economy will be growth in business investment, which ought to be good for industry serving companies such as mining services or engineering, as well as IT and consulting type companies. He says export sectors should benefit from the relatively good performance of emerging markets. And he argues this ought to feed through to good performance of Australian consumer stocks like retailers. Longer term, the rationale for housing looks solid; “I acknowledge we might have an affordability problem with Australian housing, but we have a housing shortage here, and that shortage is destined to be let off the hook at some time. An undersupply of housing waiting to be fulfilled suggests a good outlook for property development stocks and companies supply that sector such as building materials.” He also takes what he acknowledges is “an unpopular view” and makes a case for banking. “I think the banks have significant valuation upside. They are priced for a pretty pessimistic outlook at the moment; reduced margins, political and regulatory difficulties are priced in there already. So if you have a more positive view on the economy they may surprise to the upside.”

But while portfolio managers find opportunity in divergent areas, they agree on one thing. As Spooner says: “This is a market to be judicious in – to take your time.”

BOX: HOW TO INVEST

Six ways of getting market exposure

Shares: The time-honoured method – call your broker (or, in the modern world, more likely just log on) and buy shares directly. The only costs you will face are brokerage, but your exposure will be based directly on the individual stocks you hold with no professional advice behind you – unless you buy an index (see below).

Exchange-traded funds: They behave like any other share and are listed on the stock exchange, but they represent the performance of a whole index or commodity. In Australia this varies from the long-standing State Street products that track the S&P/ASX200 or 50, to iShares products mirroring international indices, and others tracking gold or silver. They have very low internal fees.

Listed investment companies: These are like ETFs in that the purchase of one share buys you a whole portfolio, but LICs are typically like managed funds rather than passive index trackers. Also, unlike ETFs, their share price does not directly match the performance of their underlying holdings and can move to a discount of premium.

Managed funds: You put your money with a professional fund manager in a unit trust structure. Your money is pooled with that of other investors, and the manager puts it where they think best. You get professional advice, and you pay for it in a fee.

Individually/Separately managed accounts: A halfway house between managed funds and direct shares. A fund manager still does the stock selection for you, but unlike a managed fund you own the underlying shares, rather than just units in a trust. This can have tax benefits and allows customisation.

Contracts for difference: A growing part of the market which stands out for the fact that it allows you to apply leverage – getting more exposure for your money, which can be good or bad depending on how the market fares – and can take short positions, which means benefiting from the decline of a stock’s value.