All Systems Go

While the market continues to struggle with the twin threats of inflationary fears and rising bond yields, it is worth reflecting on the main reasons for the ASX 200 Accumulation Index rising by nearly 60% in the two years to the end of September.
Above-average earnings growth has been the main factor pushing the market in that time, as indeed it is for the long term. But there are other reasons:
- Earnings for the ASX 200 have compounded by 21% between 2002-03 and 2004-05.
- US interest rates at 45-year lows with the Federal Funds Rate at 1%, provided an attractive asset allocation stimulus for equities.
- The industrialisation of China and the super cycle for commodities continues to be a huge positive for the Australian economy.
- Liquidity has also been an important issue, with strong corporate balance sheets enabling companies to pay record dividends and provide capital management initiatives.
- Lastly, but just as importantly, compulsory superannuation flows, when combined with full employment, have completely changed the demand/supply fundamentals for the Australian equity market.

Although earnings growth is forecast to slow this year, the consensus is that ASX 200 companies will enjoy earnings growth of 12% in 2005-06, well above the long-term average of 8%. That 12% average EPS growth number will prove too pessimistic due to resource sector earnings being under-estimated yet again. Further, short-term rates and long bond yields remain low by historical standards; otherwise, the other positive drivers of future performance remain firmly in place.

I expect the upcoming AGM season will confirm the positive earnings outlook for most of corporate Australia and the ongoing strength of the economy. The few companies that have held AGMs so far have confirmed this trend.

However, I believe that the general uplift has swept some companies to unsustainable levels, and I remain cautious on some sectors; those that have risen faster than earnings revisions are vulnerable. I think that has happened in health care, utilities, infrastructure, and investment banks. These sectors also appear to be the most voracious raisers of new capital. Sonic Healthcare (SHL), for example, raised $200 million at record share prices yesterday to "pay down debt". I don't support equity issues that are simply to "pay down debt", particularly in stocks that have had huge runs.

I believe it is prudent to remain largely exposed to stocks with low price/earnings (p/e) multiples, and those that also offer above-market earnings per share growth and yield inside that low p/e. I also believe that increasing the "visibility" and "transparency" of earnings within an overall portfolio is prudent.

I also believe it's prudent to align your investing interests with the strongest boards and management teams. It gets a little tougher from here, with inflation in the system and interest rates rising globally, and you don't want to be holding companies whose strategic direction is going to be found out during this process.

Some might think it's a little controversial that I name individuals who sit on corporate boards in my overall assessment of a stock, but I disagree. I think you should look at the board composition first; look at members’ collective experience and their collective track record. Look at the age of directors and their personal shareholdings. I think it's also important to look for experienced women on boards.

Many people, particularly analysts, forget that the board sets the strategic direction of a company, and the management executes it. The earnings are a derivative of the strategy's successful implementation, combined with macroeconomic and industry specific influences. I think many analysts concentrate too much on the "tail" (earnings), and not on the "dog" (the company). Investing is as much about backing "people" and "culture" as it is about backing "assets" and "industry structure". I have great faith in the quality and skill of the boards and management teams in Australian companies, which is why I believe that Australian equities will move to a 20% price/earnings premium to their global peers over the next five years.

Infrastructure party’s over

I don’t always see eye-to-eye with Anton Tagliaferro of Investors Mutual, but I do agree with some points he was reported to have made on infrastructure stocks this week. He likened the sector to a trapeze artist: while the music is playing and the crowd is cheering it looks so easy, but when the music stops there is no safety net to protect him from a large fall.

There has clearly been a "bubble" in the Australian listed infrastructure sector, and I take a completely different strategic view on this sector from other brokers. They recommend buying big listed infrastructure stocks whenever their shares dip in trading; I recommend selling into any rally. It's over for these stocks, and it's getting harder for the "motherships" who rely on their performance fees.

It’s interesting to see the market capitalisation of Macquarie Bank (MBL) has fallen by a cool $1 billion since former NSW Premier Bob Carr was appointed a consultant. Is Bob the problem, or am I seeing the market move away from industrial stocks that trade at p/e premiums to the market, and lack a degree of earnings visibility? I suspect this is all about visibility, and that Carr's timing was a little unfortunate, or fortunate, depending on which way you vote.

You can see that other financial stocks that lack a degree of visibility have been hit hard over recent weeks, with Challenger (CGF) and Babcock & Brown (BNB) both losing double-digit percentages from recent highs.

What I believe I am seeing is investors saying to themselves, "I have made good money in this stock, I don't really understand how they make money, every analyst has a buy on them, I'm going to sell them".

I honestly think we are seeing a rotation from companies that are difficult to model financially, to traditional, easy to model, industrial companies. The largest profits the market has to take from the past two years are in "financially complicated" industrial companies, and I think this will continue as bond yields rise globally.

It's basically a "show me the money” attitude from investors, who want to know specifically how their investments will generate cash over the next 12 to 18 months, and not simply rely on falling interest rates to lift valuations.

Charlie Aitken is a director of Southern Cross Equities