Equities on the return journey

Can the great Australian equities rally continue?

The short answer is yes. But the frenetic pace that has caught many experts off guard in the first month of 2013 is almost certain to moderate, and possibly even take a breather during the next month or so, as corporate Australia delivers its half-year earnings.

There is a lot of talk about “great rotations” right now. And one of the more curious is the rotation in attitudes between those with funds (buy-side analysts) and those in the broking and investment banking world (sell-side).

In normal times, optimism abounds among the salesman. The buyers, on the other hand, tend to be far more sanguine. Not at the moment.

Late last year, we reported that funds managers were switching back into equities as the yields on fixed interest dropped. Some, such as Wilson Asset Management’s Geoff Wilson, were openly talking about the return of a bull market.

By contrast, at year end, the investment bankers – having had their optimism dashed three years running – were an overly gloomy bunch, worried that corporate earnings this year would not grow enough to justify the surge in stock prices since June 2012. In recent weeks, many have seen their full-year growth targets for the ASX 200 exceeded and are now busily revising their forecasts.

Judgement day is now upon us. And while the fears of brokers are likely to be realised – there is unlikely to be any great surge in corporate earnings in the financial year first-half – they have collectively overlooked a fundamental driver of equity markets.

Most have been concerned that the Australian market has moved beyond its 20-year average price earnings multiple of 14.4, with little immediate prospect of earnings growth. That puts it into overbought territory, they postulate.  

On its own, that’s a reasonable argument. But put that against interest rates, not just below their 20-year average, but at all-time lows, and you have a fundamental justification for a P/E rerating of the Australian sharemarket.

Rotating expectations

Equities markets are more about expectations than past performance. And so, earnings surprises aside, the outlook statements generally are more useful in determining stock price movements than the delivered results.

That said, here are a couple factors that will override the conventional wisdom on stockmarket direction and individual stock performance.

1. The yield play will continue to dominate at least for the remainder of this financial year. Safety and return will remain uppermost in the minds of most investors.
2. While there have been signs of an improved global economy, non-mining sectors in Australia remain sluggish, as evidenced by this week’s building approvals, maintaining pressure on the Reserve Bank to further cut interest rates. The hunt for yield will intensify. Cash will continue to flow out of fixed interest and into equities.

It is worth noting too that the great rotation currently in place is not confined to equity markets. Just as the laws of physics dictate that gas will flow from areas of high pressure to low pressure, the more benign global economic situation will force money to flow out of bonds and “safe haven” areas into riskier investments.

In the past few months, the euro has appreciated significantly against the US dollar as the threat of a European Union implosion has receded. Money has been flowing into commodity markets as well.

In the medium to longer term, this has implications for the Australian dollar. With the investment phase of the resources boom peaking and then tapering off in 2014, the Aussie dollar is likely to lose its lustre as a safe haven. A weaker dollar – to say $US0.95 – would deliver an earnings boost to companies with US exposure along with exporters and those competing with imports.

So the equities strategy should be: Stick to yield stocks now, but keep an eye on opportunities for trade-exposed corporations.

Open season

Earnings season has already started but, in terms of sheer numbers, it doesn’t really move into top gear until next week. Among the more notables, Primary Health Care was out today, posting a 50% jump in interim net profit to $69.53 million on the previous corresponding period, while Cochlear reported a huge 481% profit rise to $77.66 million. Cochlear has pointed to strong long-term growth, however investors have sold down its shares since the announcement by around 13%. It seems that share price volatility remains, even when good news is announced. Australand, Tabcorp, News Corp, and Telstra will dominate proceedings tomorrow when they report their latest figures.

Telstra, one of the big winners of 2012, is trading on a forward P/E of 17.1, making it one of the world’s most expensive telcos. But for sheer earnings and yield certainty – its 6% yield rises to an estimated 7.7% by 2015 on current share prices – it deserves its premium.

The focus in tomorrow’s earnings will be on its growth in mobiles, not just overall market growth but its margins. Telstra’s business model is in the process of rapid evolution, from fixed line wholesale and retail to pure retail.

This was forced upon it by the Rudd government’s decision to impose structural separation upon the company and the current management’s brilliant settlement negotiations. Clearly, it was the best thing to ever happen to Telstra shareholders.

All eyes will be on the retailers this half year. Investors have flocked to the staples, Wesfarmers and Woolworths, pushing their stock prices into the upper layers of the atmosphere. But the key measure – for whether consumers have become less parsimonious – will be found in the discretionary retailers.

Two smaller apparel groups, Specialty Fashion and Kathmandu, recently announced earnings upgrades based on better sales and inventory control. JB Hi-Fi, which reports next week, will be a litmus test as to whether consumers really have loosened their purse strings. On the bigger discretionary retailers, Myer is outpacing David Jones. But again, both will be important pointers to consumer behaviour into the future.

After a horror stretch last year, resources have found themselves back in favour. Iron ore producers, having endured wildly gyrating prices during the first half, no doubt will be highlighting the skinny inventories on Chinese ports as justification for renewed optimism in the year ahead.

Coal producers, particularly those with heavy capital expenditure commitments such as Whitehaven and Sedgeman, are likely to feel the strain.

Call me a conservative, but when it comes to resources, diversified operations win out. And the most diversified is BHP.

Hit list

For what it’s worth on the earnings growth versus share price debate, Macquarie Private Equity yesterday delivered this list. It is based on fairly recent stock price movements.

Market darlings with limited earnings growth prospects include:

AMP, Wesfarmers, Toll Holdings, Leighton, Iluka Resources, Simms Metal Management, Aurizon Holdings, Aristocrat Leisure, Fletcher Building, Wotif.com, TEN Network, Fleetwood Corporation.

Stock price laggards with good earnings growth prospects include:

Carsales.com, Brambles, Ansell, Domino’s Pizza, CSL, REA, GPT, Telstra, Investa Office Fund.