Big end of town still winning

Stockmarket growth has been weak so far, but there are profit opportunities.

Summary: Mid-cap stocks have outperformed the broader market, including the largest listed stocks, reflecting a combination of M&A activity and macro thematics. But the top 50 still present solid growth opportunities for investors.
Key take-out: Interest rate sensitive sectors – property, construction, consumer – will continue to attract M&A action, including large and mid-cap stocks.
Key beneficiaries: General investors. Category: Shares.

2014 has so far seen the softest stock performance in a few years, with a 3% year-to-date gain.

That’s the worst performance since 2011 to be exact, when the market was up just over 1%. To put this into some perspective, that’s about one-third of the gain we saw at the same time last year and half the year before that. Now there are a few reasons for this soft performance obviously:

  • A view that valuations are stretched.
  • Concerns over earnings.
  • Global markets are weak.
  • Persistent concerns over China.
  • Over the Ukraine crisis, maybe.

That list is obviously not exhaustive, and within that we had concerns over the US tech sector and US earnings more broadly – all of which has weighed. Underlying all of this is the fact that there seems to be a void in the market at the moment – no narrative, no themes. For instance, we already know the US economy is expanding, rebounding from a winter lull – we know the Australian economy is too. The themes dominating the last few years, the debates, are largely settled.  Already, value investors seem to have given up and are increasingly piling into cash.

Despite this, we are seeing areas of opportunity. In the Australian context this has been most easily observed in the mid-caps space. Take a look at chart 1 below.
Graph for Big end of town still winning

As you can see from the chart, mid-caps haven’t had a bad year so far, up 5.7% year-to-date compared to the broader market’s 3% rise. Over the last six months this index is up 7%, whereas the broader market is only 1.4% higher.  The top 50 stocks, in contrast, are up by 3.1% YTD and 1.3% over the last six months.
Graph for Big end of town still winning

As far as I can tell the outperformance of the sector as a whole is reasonably broad-based, as 29 of 50 stocks have posted gains of 5% or more. The logic goes that this was to be expected. Large-caps have had a hard run; in fact for 2013 large-caps outperformed mid-cap stocks by a decent margin, although both had a good year – 16.8% vs 12.6%. The top 20 stocks did even better, with an 18% gain.  So the logic is that the larger blue-chips, having done their dash, no longer offer value and investors are looking for better value elsewhere – mid-caps.

Truth is, it’s not as simple as that. As chart 3 below shows, larger-cap stocks are actually that little bit cheaper than the mid-cap 50. The current trailing earnings multiple is around 1 times the average for large-caps and more like 1.1 times the average for mid-caps. On a forward basis the mid-cap 50 have a multiple of 15.75, while large-caps are at 14.47. Effectively this places large-caps at a discount to their average, whereas, and even on a forward earnings basis, mid-caps are trading 1.03 times average. That means, if anything, there is better value for large-caps, and the outperformance of the mid-cap 50 is not a generalised value story.
Graph for Big end of town still winning

So what’s going on? Well, as always, aggregate indices can hide the key themes. If we take another look at chart 2, and scan other outperforming stocks in the mid-cap index, several themes emerge.

Firstly there has been a bit of M&A activity in the space:

  • AUT (Aurora:) Share price surge due to a $4.10 per share takeover offer.
  • DJS (David Jones): Share price surge due to a $2.15 billion takeover offer.
  • LEI (Leightons): Hochtief’s off-market offer to acquire more shares.
  • ORA (Orora): Demerger from Amcor in December. Strong revenue growth since.

Naturally enough, and as we’ve seen in global markets of late, M&A or takeover activity is picking up. Corporates are cashed-up, balance sheets are pristine, and earnings are getting harder to come by. That usually leads to M&A. In the Australian context you would expect most of that activity to continue in the small to mid-cap space.

Secondly, there are some key macro thematics working in favour of the mid-caps. Boral and James Hardy both sit in the mid-cap 50, and we know the housing construction rebound both in Australia and the US is well underway. These stocks have surged. Otherwise, some like SEK (Seek) are just well-run companies on to a good thing.

That’s not to say that there has been no interest in large-cap stocks. The headline index may not be pointing to much, but it’s there beneath the surface. The drivers are different though. The key themes hitting our larger-cap stocks include the following:

  • Redemption. In many cases, the top performing stocks so far this year have a turnaround story – a base effect ( i.e. a bounce from a low price) rather than any huge vote of confidence (NCM, AMP).
  • Yield switch. Not so much a switch from yield to growth. But a switch into cheaper yield.  You can see this in two ways. REITS have performed well (GPT and DXS), but so have ANZ and Westpac at the expensive of CBA, and NAB. Telstra, another favourite of 2013, in contrast has lagged. It’s not all bad. Some well-run family favourites have continued to perform. In this place I would put Woolworths and Lend Lease – but they are a minority.  

So can we profit from the void? Looking at what interests the market at the moment – the key dynamics – I think the answer is yes, although I think it’s going to be more complicated than just buying mid-caps or what have you. The idea our large-caps are generally expensive and that better value is elsewhere doesn’t wash for me, so it’s going to be tough and it will require a good deal of research.

The above points do give us a starting point though, and investors should notice one important fact from them.  Whether it’s M&A, earnings discovery, yield or whatever, low interest rates are still working their way through the economy and influencing investor behaviour.  

Investors should continue to look for opportunity here, whether it’s M&A, a consumer rebound (note Woolworths Q3 sales) or simply just yield. That is the interest rate sensitive sectors – property, construction, consumer.  This is where the action has and will continue to be – large and mid-cap. Indeed food is obviously still a big one, as we can see with recent interest in Goodman Fielder. Note also Tom Elliott’s April 9 note (click here) highlighting GrainCorp and Treasury Wines as possible targets. Merger or takeover activity is likely to be an ongoing theme for the near-term; we’re seeing it in the US and we’re seeing it here. Balance sheets are very healthy.

Secondly, price action to date and certainly the rhetoric from fund managers show that there is still a lot of interest in high-yielding blue-chip stocks – the banks, Telstra etc. Price action to date suggests interest will wax and wane according to perceptions of value, and certainly risk tolerance is rising. Retail investors should consequently feel more comfortable seeking yield in higher-risk categories like REITS.

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