Highly Prospective

Banks and resources companies are often seen as adversaries: when one sector is in fashion it's probably better to ditch the other one, and vice versa. However, there are times when both are considered good value for equity investors and this may well be one of those times.

The reason lies in the different forces at work in the global equity markets. Think higher interest rates, slowing economic growth, a rebalancing global financial system and the end of the big liquidity boom.

To some investment experts the recent correction has not so much to do with a change in market views or with more or less risk appetite among investors. They believe the dominant force behind the May-June market jitters has been changing money flows on an international scale.

The idea has gained support recently from market experts at some of the world's largest financial institutions, such as Citigroup, so one would assume there must be some truth behind the theory.

Whatever the cause behind the changes in money flows across the globe over the past few weeks, it can hardly be denied that they have had a significant impact on global investor sentiment in general. In other words: if a reversal in risk appetite among investors did not cause the recent correction, surely the correction itself has now caused investors to become more cautious. The end result is, of course, the same.

Usually, in such an environment, most investment experts would advise investors to go defensive. Think property trusts, food and beverage companies, infrastructure owners and toll roads.

Most of these sectors have been cast aside over the past year as interest rates in the US and Australia have climbed higher and this affects the valuation of long-term assets as bond yields adjust to the higher interest rate environment.

The current forecast is for listed property trusts to generate on average a total investment return of 4–5% over the next 12 months. Unless you have a very subdued view on how things will pan out in the near term, this does not look like a highly attractive option.
The problem for food and beverage companies is '” grape problems aside '” higher costs. Coca-Cola Amatil, for instance saw its production costs rise by more than 30% as prices for products such as sugar and aluminium have increased steadily, yet the company is only able to pass on about 5% of the increase to Australian consumers '” if competitor Pepsi is willing to cooperate.

Real safety, of course, comes from earnings with a high degree of reliability (low chance of downward adjustments in the near term) in combination with price/earnings (P/E) multiples that don't look stretched. Once you've seen a few market corrections, you'll remember that high P/E companies feel the pain much more than low P/E companies.

The recent sell-down has been no exception. In fact, it has firmly highlighted the strong defensive qualities of the supermarkets in Australia, a fact that may have got lost at a time when many stocks lost 20–30%, or even more, over the course of a few weeks. Shares of Coles Myer lost very little during the period. Woolworths shares lost just 4%.

Since mid-May, Australian banks have lost a little more than 10%. Although few experts would describe the sector as cheap, most analysts and market strategists would tell you banking shares are now closer to fair value. Of equal importance is the fact that they match the profile investors turn to in a more cautious environment.

If sector earnings will be scaled back over the next few months '” and that is a big if '” it will only be by a few percent. Such is the nature of the sector's earnings in Australia. Meanwhile, the banks remain among the largest dividend payers in the market. And they can still surprise during the upcoming results season.

At FN Arena, we compared the average price targets set by the leading stockbrokers in the Australian sharemarket with current share prices. The exercise clearly shows the banks stand out as a safe haven within the current environment.

Whereas the implied upside share price potential for stocks such as Coles and Woolworths seems to consist of dividend payouts only (these stocks are trading at or close the average price targets already), most targets for banking stocks are 10% or more above today's share price (add dividends for total projected investment return).

Of course, not all banks are equal. Commonwealth Bank's average target of $43.34, for example, only implies minimal further upside, but for the likes of ANZ, Westpac and National Australia Bank, the average target price foresees at least 10% in return plus dividends. Bank of Queensland shares should appreciate a little less. The outlook for Bendigo Bank and Adelaide Bank looks even worse than for CommBank.

Top of the list is Macquarie Bank. Its average price target may be somewhat distorted by the $97.49 target set by JP Morgan, but even if we leave that one out, the remaining price targets still imply today's shares should be 20% higher over the coming year, plus dividends.

The largest upside, however, is to be found among resources companies. The sector has been hit the hardest during the recent sell-off, but earnings forecasts have not come down and neither did the price targets. As a result, the forecast upside for the likes of BHP Billiton is for 30% (or more).

The option comes with increased volatility. Growth in China and the US will slow down from here, but most experts will tell you demand for most basic materials will remain strong enough to keep prices above trend.