Bargains on the growth path

I mentioned a couple of weeks ago (Stay with the yield play) that yield stocks were still a good investment, and that retail investors should resist the advice to ‘switch’.

However, that view wasn’t, and isn’t, based on what I think are poor prospects for ‘growth stocks’. It’s just that I think some of our biggest yield stocks, like banks, have a growth story as well – the housing boom is only in first gear after all, and it’s got a long way to run. As one reader put it to me, it’s a definitional issue. And I don’t think at this point that there is always a clear distinction between an income or growth stock.

Indeed, given my macro view, I think ‘growth’ stocks as a general rule are very attractive. Yet I’ve been arguing that investors go overweight Australian equities rather than switching out of their yield per se. The problem is trying to determine which growth stocks are attractive at any given point, although coming into the December quarter it might be a little more important than usual to try and pick this. That’s because, historically, the last quarter is the best performing (statistically for the All Ords).

The first thing to note is that the rally, so far, does reflect more positive sentiment towards Australia, in particular, and our stocks are outperforming global peers. I have written before about why our market might outperform over this period, although having said that, the second thing to note is that there isn’t necessarily an overarching theme driving things. For instance, there’s no theme such as growth over yield, or even cyclical over defensive. Cyclicals have outperformed as a general rule – but a 10% quarter-on-quarter gain (6% over the month) for stocks like Sonic Healthcare put rest to the idea that there is a sectoral rotation into cyclical stocks. The same applies to CSL and Woolworths’ year-to date performance. Adding to that is the fact that many cyclical stocks have not performed particularly well.

Click to enlarge

The key outperformers, in the large cap world, are shown in the chart above, ranked according to their performance over the last month. But I’ve also added in the three-month performance to give a bit more perspective. The rankings don’t change too much between a one and three-month view anyway, although on the longer view you would take out Macquarie, Iluka, Origin, Toll and Suncorp and put in Twenty-First Century Fox, Asciano, Santos, Rio and NAB. In most cases, you’re talking the difference of a few percentage points.

Either way, the thing to note is that the strong rally over the last quarter or month has had good sectoral representation, without any gain being particularly representative of a sector – except, that is, for our miners. There has been a broad-based reassessment here and the rally has been strong for many stocks. This, of course, comes down to the fact that China didn’t have a hard landing and iron ore prices didn’t slump. It’s interesting to note that when you look at some of the other stocks on the list above, a key uniting themes is also one of unrealised pessimism. Seven of the 10 best performing stocks over the last quarter fit that mould – and Fortescue is the poster child. These are stocks that lost favour with the market for a variety of reasons – usually based on misnomers. And really what we’ve seen, and what has driven this rally in the large cap space, is a correction from those views – almost like some redemptive fervour. Fortescue was obviously about China, while for Worley Parsons it was an earnings downgrade in the first quarter that ended up not being so bad – it was soon followed by some big contract signings, a broker upgrade, and better-than-expected earnings results. It’s a similar story for Toll Holdings and Sydney Airport.

But can this kind of redemptive fervour see continued strong gains for a stock? I suspect it can when it’s been preceded by five years of stagnant growth. That’s especially the case when you can attach a positive growth story to the picture. Now, while this might characterise the entire Australian market, there are some stand-outs for me – especially on the growth side – and these are the stocks that I think have the greatest potential to outperform or continue to outperform over the next six to 12 months given current market sentiment.

Combining an unwinding of consumer pessimism with an actual positive growth story, real estate stocks stand out. I’ve been bullish on property for some time, and now the market is responding. What I’m still surprised about is how much value is left in the market. Lend Lease, for instance, is up 23% for the quarter and 11% for the month. Yet, even after that run, the stock is still  cheap with a price-earnings ratio of about 10 on a trailing basis, and not much more than that on a forward earnings basis – 11-12. It’s a similar situation within some of our key A-REITS. Strong gains over the last month, quarter, or year, really only take many of these stocks to the top (or just above) of their trading range for the last five years. There are good reasons for that – earnings have been subdued.

Yet, with the property sector rebounding, the scope for strong earnings growth is high. Mirvac and Stockland are my preferred picks in this space, up only 5% or so for the month – 8% and 11% respectively for the quarter. But neither stock has really moved since the GFC. I probably prefer these to either construction stocks in that space (Boral, Brickworks and Adelaide Brighton) or even our retailers in the consumer discretionary space. It’s the same growth story at play, but there are rightly some concerns about whether the construction cycle will actually take off, and any decent retail stock is still comparatively expensive – think JB Hi-Fi, Automotive Holdings, and Super Retail Group.

Other than that, positive global growth momentum, the beginnings of a turnaround in Australia, and a renewed focus on infrastructure development by policy makers domestically suggest other candidates for outperformance, from a macro perspective, include Leighton and Toll Holdings.

Naturally, I still think some of our miners are very cheap. Fortescue, in particular, still looks very cheap with a price- to earnings ratio of 6-7 on a trailing and forward basis. Certainly, China is unlikely to have a hard landing and the emerging market story having decades to run. I’m not a believer in the end of the mining boom view. But the market seems unwilling, despite attractive valuations, to take any of our miners back to the peaks reached early this year or last. It’s a very difficult space to invest in.