Taking stock

THE AUSTRALIAN share market has risen dramatically since June of last year – but it may not feel that way to every investor.

While the financial sector shot the lights out with close to 40 per cent returns over the 2012/2013 financial year, the materials sector was in the red.

In the 12 months to 30 June 2013, the financial sector (excluding Australian real estate investment trusts, or A-REITS) returned 39 per cent to investors. Materials, on the other hand, lost investors just under eight per cent.

The benchmark weighting of financials (excluding A-REITs) went from 34 per cent of the ASX 200 at 30 June 2012 to 38 per cent at 30 June 2013. The materials sector fell from 22 per cent of the benchmark to 17 per cent over the financial year.

The slowdown in China has taken its toll on the mining companies as the significant ramp-up in production during the ‘mining boom’ now meets a fall in demand.

But commodity prices have, for the most part, held up quite well, although no one seems to be able to explain the remarkable resilience of the iron ore price.

The financial sector, on the other hand, has benefited from a global environment of declining interest rates as investors eye high Australian bank yields.

Gaining weight

For the most part, fund managers have reacted to the run-up in the financial sector and the accompanying decline in resource stocks by reweighting their portfolios.

Colonial First State’s (CFS’s) Scott Tully is head of FirstChoice Investments and oversees $25 billion managed by Perennial, Tyndall Asset Management, Schroeders and Alphinity.

“Our managers have gone from underweight materials and energy to overweight materials/energy and underweight the banks and property trusts,” says Mr Tully.

The shift in weightings is as much a reflection of the shift in prices as anything else, he says. Fund managers suspect the financials have run too hard, and the miners are oversold.

MLC’s head of Australian shares research, Peter Sumner, says the managers in his multi-manager fund have gone underweight the financials, but are selectively overweight energy stocks.

As for the miners, MLC’s managers like Rio Tinto but they are slightly underweight in the resources sector overall.

However, Hyperion Asset Management’s senior investment analyst, Joel Gray, says his firm is “very underweight” in the resources sector.

“We’ve never been really big on resource companies. We want predictable companies and mining companies generally don’t fit that bill,” Mr Gray says.

Hyperion is also overweight in financial companies, particularly AMP and Macquarie, he adds.

K2 Asset Management’s head of Australian strategy, David Poppenbeek, says his fund believed 12 months ago that interest rates were going to fall, China was going to slow and major resource companies would continue to expand regardless of what happened in China.

As a result, K2 avoided having what Mr Poppenbeek refers to as “lazy capital” in the big cap Australian companies.

Given how well Australia performed through the global financial crisis (GFC), Mr Poppenbeek says he is surprised that both business and consumer confidence are not stronger.

He points to the $350 billion in secondary equity that was raised during the GFC – something no other country did “to that magnitude”. “What the Australian-listed companies did was they took that capital and they retired debt,” he says.

By contrast, US-listed companies instead chose to “smash their cost base” – which explains why US unemployment went from 5 per cent to 10 per cent so quickly, Mr Poppenbeek says.

“The US companies just panicked and reduced costs,” he says. “Our listed companies didn’t panic; they used the equity market for what it’s there for.”

Because Australian companies raised even more equity than they needed to pay down debt, they have been able to return capital to shareholders in the form of healthy dividends, Mr Poppenbeek adds.

All quiet on the home front

Australian companies have just emerged from a “reasonably benign” reporting season, with profits and earnings growth in the low single digits, but according to MLC’s Mr Sumner, top line growth has not been particularly strong.

In general, companies are busy “attacking their costs base” and are not looking to invest a great deal of money, he says.

There has also been very little, if any, dividend growth – something that is hard to sustain if top line growth is lacking.

As a result, the domestic environment is still “somewhat anaemic”, according to Northward Capital chief executive and lead portfolio manager Darren Thompson. There is a distinct lack of organic growth in the earnings of most Australian companies.

That’s not a great environment for consumer discretionary spending or the domestic economy, says Mr Thompson.

“As mining [capital expenditure] and spending is coming off we’re not really seeing spending coming into the domestic economy,” he says.

Australians are also changing their consumption habits, which is making online companies look a lot more attractive to fund managers.

Aberdeen Asset Management’s head of Australian equities, Robert Penaloza, says Australian retailers are undergoing a structural change in which they are seeing increased competition on two fronts.

“For the longest time it was always domestic competition, but now it’s international competition. Australian companies have to fight online, and they have to fight competitors that aren’t on their home turf,” says Mr Penaloza.

It will be a painful transition, but Australian retailers will come out of it on the other side looking much stronger, he says.

Hyperion has responded to the trend by taking up holdings in companies like CarSales, Seek and REA Group.

“They’ve performed pretty well, they have a strong value proposition, and when people are watching their dollars those companies shine out,” Mr Gray says.

China’s slowdown

One of the most significant concerns for investors at the moment is by how much the Chinese economy will slow down.

Aberdeen’s Mr Penaloza says he expects growth in China to be below 7.5 per cent for the foreseeable future. However, he points out that the Chinese government has already “shown its hand” and that it will intervene in the economy if necessary to prop it up.

But the market is probably missing the point when it comes to China, he continues, and at a time when the world economy is growing at 2 or 2.5 per cent, 7 per cent growth in China is still pretty impressive.

“If you’re feeling hot on one side and cold on the other, then you’re basically sick – and the Chinese government knows that and it’s trying to address it,” says Mr Penaloza.

Australia well and truly hitched itself to the Chinese growth story in 2009 and 2010 when resources companies made significant capacity increases to meet Chinese demand, according to AMP Capital’s senior portfolio manager, global resources, John Payne.

But that demand is now falling off as the Chinese economy begins to slow.

“The Chinese government has said it wants to slow growth to about 7.5 per cent, and they’ve been managing that very well,” Mr Payne says, adding that on the positive side, the resources sector is “very definitely” at the bottom of the cycle.

As evidence, he pointed to the healthy valuations of Australian materials stocks, with price multiples of 25 times forward price/earnings ratios – along with indications that the Chinese economy now appears to be stabilising.

“Couple that with a weaker Australian dollar, [and] I think that the resource stocks are positioned now to be at the bottom of the cycle and I think we’re probably going to see some earnings upgrades going into the fourth quarter of this year and then 2014,” Mr Payne says.

Looking at the global hard asset sector, Mr Payne says he is “very bullish indeed” – particularly considering that “we have not seen a collapse in commodity prices”.

Nevertheless, the thing Australian resources companies have to be mindful of is the blowout in labour costs.

“BHP and Rio came out last year and proactively reduced their cost base … the pressure on costs has to be sustained because

Australia has lost competitiveness internationally,” Mr Payne warns.

Meanwhile, according to Kate Howitt, who manages the Fidelity Australian Opportunities Fund, investors are starting to challenge the big miners on their capital expenditure.

“BHP has had a progressive dividend policy – it goes up a little bit year after year. The question that investors are asking of BHP and Rio Tinto is: Do you implicitly also have a progressive capex policy?” she says.

Both BHP and Rio have gone through a period of massive investment into their businesses, but not much of their earnings has gone back to shareholders, says Ms Howitt.

But then again, perhaps investors should have been more vigilant about questioning capex during the boom years when costs were at their peak, she adds.

“This is the whole problem with the capex space: everything about it is cyclical. So they all rush to invest when the price of big yellow trucks is at its highest, and they rush to buy each other when the prices are at their peak,” Ms Howitt says.

So even though it may make sense to reinvest into businesses now while costs are relatively low, mining investors are arguing against expanding the supply base when demand is shrinking. Investors want to see some cash from the big miners, she says.

The hunt for yield

One group of investors who are hardly in a position to complain about their dividend payments are the shareholders of the big banks.

The banks, property trusts and other high-yielding stocks like Telstra have all seen a strong run in their share prices as investors hunt down income.

According to CFS’s Mr Tully, the banks are paying out large dividends – close to five per cent fully franked.
But the more conservative fund managers believe a pull-back in the economy, a lack of growth in lending or an increase in defaults may put the ability of the banks to continue paying out those dividends under pressure, he says.

Mr Tully believes the marginal retail investors (the ‘mums and dads’) are going to continue to buy bank stocks because they pay a strong dividend.

High franked dividends are particularly attractive to people who are in the pension phase, which will likely act as a support for the banks’ share prices, he adds.

But Australian banks are very expensive compared with their counterparts around the world. Indeed, some are at their pre-global financial crisis highs – whereas some banks overseas are sitting at half pre-GFC levels.

“CBA is probably the most expensive bank in the world,” says Aberdeen’s Mr Penaloza. “It certainly warrants caution.”
In addition, there are concerns about the bad and doubtful debts of the big banks. The bears’ argument is that they have been so low for so long (currently sitting at just 0.17 basis points, by some estimates) that they can only go up from here.

Morningstar head of equities Andrew Doherty says all of the stocks his company covers are fully priced on a price to fair value basis.

“Price relative to fair value was at a 20 per cent discount in June 2012. But now it’s on 100 per cent. There’s no discount anymore,” says Mr Doherty.

Morningstar is currently neutral overall on the Australian market – with many ‘hold’ recommendations. Investors can expect decent returns over the next 12 months, but “nowhere near what we’ve seen in the last year”, says Mr Doherty.

“We’re encouraging greater than usual weighting to defensive stocks, like most of the utilities and telecommunications and supermarket retailers. Stocks which are still not expensive, but are trading around fair value and offer above average yields,” he says.

It’s also worth looking at some companies that have some offshore exposure, says Mr Doherty.
Macquarie Private Wealth head of research Riccardo Briganti says there is more certainty in the United States than Australia, and as a result, he likes companies that are leveraged to US growth, such as James Hardie or Computershare.
“These are cyclical companies but they’ve got more exposure to global growth than domestic growth,” he says.

Tapering on?

One of the most significant challenges investors face is the prospect of the US Federal Reserve slowing, or ‘tapering’, its monthly bond purchases.

The talk of tapering began in earnest in May, and global markets have been skittish ever since.

According to Macquarie Private Wealth’s Mr Briganti, it comes down to whether or not investors trust the Federal Reserve to run US monetary policy appropriately.

“The crux for me is: Are we confident the US economy is on a stable trajectory? I don’t need growth to be strong, I just need it to be able to sustain itself,” he says. “The main question is: To what extent is that disturbed by the Fed tapering?”

According to Fidelity’s Ms Howitt, the prospect of the US Federal Reserve slowing its asset purchasing doesn’t necessarily mean the yield story is ending.

It’s hard to construct a scenario in which the United States can tolerate a 10-year bond rate much above 3.5 or 4 per cent, given that residential mortgages are linked to that number, she says.

“What we’re talking about is US rates going from close to zero to a bit above that. Now in that environment, the search for yield is probably still on,” says Ms Howitt.

In Australia, the move out of ‘bond proxy’ stocks (such as A-REITS, Telstra and utilities), which is already happening, may be premature, she says.

The Reserve Bank of Australia stayed its hand in September, but the consensus among Australian fund managers is that domestic interest rate cuts have not necessarily come to an end.

Take my advice

Omniwealth senior financial planner Andrew Zbik says his firm is gradually transitioning its clients into a ‘risk on’ asset allocation.

Mr Zbik, who is also on the company’s investment committee, says that because Omniwealth uses managed discretionary accounts (MDAs) for its clients, it can react to changes in the market quickly.

The company also uses exchange-traded funds in order to trade ranges in the market without churning the portfolio and keeping brokerage fees low.

“Two years ago, all conservative clients were taken out of the market. The volatility was deemed to be too great,” Mr Zbik says.

But in the past six months, Omniwealth’s more conservative clients have been re-entered into the market because the firm’s investment committee has determined the market is capable of delivering sustained returns.

Instreet managing director George Lucas sits on the investment committees of a number of financial planning firms – including Omniwealth – and says the main issue for advisers is working out what to do with their clients’ fixed income portfolios.

“Advisers have got an expectation that bonds are not going to perform very well due to what’s happening in the US,” Mr Lucas says.

What makes the situation especially tricky for advisers is the fact that they are often operating under prescriptive models within which they have to hold a certain amount of funds in defensive assets.

“That’s a big concern to them – how to manage that risk,” he says.

Advisers also need to get their head around hybrids which, even though they are linked to the bank bill swap rate (ie, the floating rate), still have a fixed component.

A recurring comment concerning hybrids is that they tend to behave like fixed income when you want them to behave like equities, and vice versa.

“Even the hybrids will behave a little bit like fixed interest, even though there’s some protection there – that’s the concern,” Mr Lucas says, adding that while there has been a bit of a rotation out of yield stocks in the USA, the same thing has yet to occur in the Australian market.

Crystal ball gazing

ifa went to press before the September 7 polling day, but Mr Lucas reckons a Coalition government could have a moderately favourable effect on business confidence and, in turn, the stock market.

“Whether it’s right or wrong, the market – both domestically and internationally – sees the Liberal Party as being more market-friendly than the Labor Party,” Mr Lucas says.

There may be more foreign money invested into Australia if the Coalition wins power, since there will likely be fewer discussions about things like the mining tax, he says.

But for Morningstar’s Mr Doherty, it isn’t who wins government that is important; it’s whether or not they have a clear majority. If chief executive officers are faced with four years of certainty, then business confidence should build, he says.

Eyeing the future direction of Australian equities, Mr Lucas says he expects Australian listed companies to do better than people expect over the next 12 months.

“I don’t really understand why the materials sector is so under-loved globally – that may change – and that would drive a good portion of our market up,” he says.

CFS’s Mr Tully says his Australian equities managers are less pessimistic about the prospect of a slowdown in China. While growth in the country is clearly slowing, it is on a much larger base – and the demand for iron ore and coal is not going a way anytime soon, he points out.

As for the banks, the conservative view of CFS’s fund managers is that the prices have gone up a lot and “they would expect it to come back”, Mr Tully says.

“We don’t see the economic environment changing much, going forward,” he says. “The things that investors have been rewarding over the last 12 to 18 months or so we see continuing.”

Nevertheless, Fidelity’s Ms Howitt says investing over the past five years has “kind of been an ugly contest of which asset class do you dislike the least”.
“We still think that equities are the asset class that you can dislike the least because there’s great growth potential upside, but still yield on offer in a lot of sectors,” she says. «