|Summary: It’s not just the high-yielding areas of the market that are delivering returns. Others have outperformed for a different reason, and there are three outstanding candidates for the next sector surge.|
|Key take-out: Sectors that will likely outperform over the next six to 12 months will likely be those sectors that surprise relative to the market narrative.|
|Key beneficiaries: General investors. Category: Economics and strategy.|
With nearly half the year done, it’s a good opportunity for investors to take stock – especially as we appear to be at another point of inflection.
The overarching theme for the market as a whole is that in spite of the bias toward economic debate being constantly pessimistic – with many financial market economists telling you how weak growth is and that the Reserve Bank must slash rates – the All Ordinaries has still had a hard run so far this year, with the ASX200 up some 12% since January 1 (table 1).
There’s certainly been a bit of a skew within that, and the favoured stocks to date have been financials, your consumer stocks and info tech. Notable laggards have been materials, industrials, energy and utilities. At this stage I don’t think anyone would suggest that the overall index is cheap, and no one does with a market price-earnings ratio of 18 compared with the long-term average of about 15. Even within sectors, and noting the skew on price performance, you still wouldn’t really argue that any sector is cheap . Even materials, and which are down by 10% so far this year, are only trading at a price-earnings ratio a little below average.
We know of course that the hunt for yield has played a significant role in driving equities higher – telecommunications have surged 44% over the year and 17% year-to-date. Our banks have had a great run as well. But this view is often overplayed and it’s important not to overemphasise it. Truth is, trying to pigeon hole this rally as some defensive play, some hunt for yield etc really doesn’t capture the market dynamics at the moment.
Price gains across other sectors, not necessarily high yielding, tell you that the hunt for yield is not the only factor driving prices higher. For instance, the non-defensive, relatively lower yielding consumer discretionary sector has actually been the best performer year-to-date. At the time the rally started in November, these stocks were giving a dividend yield of 3.9%, which is good, but still below the market benchmark of 4.5% at the time.
Discretionary stocks are not a yield play, they’re not even defensive play – the same with info tech stocks. So why have they outperformed? Earnings surprises. In the case of consumer discretionary stocks it wasn’t even the case that companies involved were posting strong earnings – just earnings that weren’t as weak as expected. And that was sufficient to see those stocks surge. This fact captures an interesting dynamic.
The market, in this age of pessimism, is highly sensitive to upside earnings surprises. Many analysts and investors are overly eager to grab onto whatever the latest pessimistic fashion item is. Up to late 2012 it was the consumer caution thesis. As this proved to be a misnomer the market corrected aggressively – there is a lesson in that for investors, because misnomers still dominate the market. This means that the sectors that will likely outperform over the next six to 12 months will likely still be those sectors that surprise relative to the market narrative.
For me, the trick in a market otherwise devoid of any obvious value is to try and pick where the earnings surprises might come from, and there are three outstanding candidates in my opinion.
Utilities have been unloved this year, rising only 9% year-to-date and 17% annually. Now 17% isn’t a bad return by any means, but it is below the benchmark of 20% and six other sectors posting gains of 30% or more. There are issues here – declining energy demand, competitive pressure and the carbon tax. But notwithstanding these headwinds, there are solid reasons why I think utilities are set to outperform.
- They offer a great and stable yield, much higher than your energy stocks with not too dissimilar fundamental divers (economic growth demand for energy etc). Apart from telecommunications though, you can’t get a better yield in the market at the moment and at current prices.
- But utilities are not only a yield story they are a growth story.
- There may be competitive pressures, but it’s a concentrated sector - three stocks comprise 70% of the index. Each of those generally shows good and stable revenue growth, a stable and high dividend yield.
- Economic growth far, from slowing, is picking up. You can see that in the pick-up in jobs growth so far in 2013. Energy/utility demand will pick-up.
- Global growth is accelerating and this means domestic non-mining business investment will lift here - good for utilities.
- It is likely that the carbon tax will be revoked.
- Financials, especially our banks:
Yes, people talk about banks being expensive and they are relative to history. However they are a great candidate for serious upside earnings surprises given that we are at the bottom of the credit cycle now.
- Our banks have strong balance sheets and are well positioned for the upswing in the credit cycle.
- They pay a high yield with scope for that to lift – it certainly won’t fall. Even at these prices, dividend yields are the third best, with perhaps one of the better potentials for growth as a sector, in the market.
- With that in mind, the big four dominate the market and hold over 80% market share.
- Materials. This covers both our miners and construction stocks more generally. Dealing first with our miners, I know pessimism is extreme. The mining boom is over and some mining services companies just this week were hammered. That being the case, I think the pessimism is unwarranted as it rests on three faulty premises, none of which have much supporting evidence. In fact, data to date shows the opposite to the following points is occurring.
- The mining boom is over.
- Chinas’ economy is slowing.
- The global economy more broadly is slowing.
I’d add that my preference for mining isn’t really an $A story either. I wouldn’t be buying any stock or any sector based on forecasts that the $A is headed lower in the near term. These have proven to be wrong for years and I wouldn’t take them seriously now. Instead I’d note that our resource stocks are cheap – pessimism on China has been, and will continue to be, just plain wrong. Full stop. China has ample policy scope to support its economy if needs be, and in any case people seem to have lost sight of a mathematical fact – China is four times the size it was in 2003, so 8% growth now has a much bigger impact than 14% growth back then.
As for construction stocks, well just consider that monetary policy is very supportive of the construction cycle (residential and non-residential) and the cycle will turn. It’s just a question of when. Note that with policymakers convinced that the mining boom is over, increasing support will be given if construction doesn’t turn of its own accord.
I guess the other way of looking at things is, how much longer can some of the other outperforming sectors – consumer stocks and telecommunications – keep pushing higher? They are expensive, without the future growth narrative that our banks have got. Yes, investors are already showing us that they are prepared to pay a premium and that premium will likely see further modest capital growth in those sectors.
I don’t have any problem with any of them, I’m just not seeing any scope for major outperformance over the next little while. In contrast, the above three sectors are where I think the action will be over the next 12 months, for the simple reason that each sector is being hit hard by poor sentiment, sentiment that is based usually on a flawed or false paradigm.
It boils down to one single truism. Investors should base their decisions on considered research and evidence – not anecdote and rumour. While our market is rife with that, it’s more fitting for traders.