Still a rough ride ahead

The sharemarket's massive rebound since March, the biggest and quickest on record, has prompted many investors to sigh with relief and assume it's back to business as usual. But is it?

The economic outlook is mixed and the revenues of most companies are flat or down. Investors, however, are accentuating the positive.

Cyclical stocks  those of companies whose fortunes are tied closely to economic growth  have come out of the blocks the strongest. Stocks such as the miners and banks, which were the most comprehensively hammered as the outlook blackened last year, are the standout performers.

However, it is not likely to be a bed of roses from here. Some companies' share prices have recovered strongly on investors' relief that the companies are going to survive the global financial crisis after all.

The International Monetary Fund (IMF) says the Australian economy will contract 0.5 per cent in 2009 and the worst of the global financial crisis could yet hit Australia. The IMF points to house prices, which are overvalued by up to 20 per cent, and big consumer debt as potential roadblocks to recovery. On the other hand, the Reserve Bank of Australia is relatively upbeat, forecasting a 0.5 per cent expansion for the economy for this calendar year.

The head of equity research at Morningstar, Peter Warnes, is optimistic for the long term but says we are not out of the woods yet. The biggest crunch to the global financial system in 70 years could not be over so quickly, he says. Consumer sentiment is still down in the US. In Australia, poor consumer sentiment is being masked by the Government's cash handouts and stimulus packages. Warnes says the most probable scenario is the market will have a breather and perhaps even pull back a little.

The most likely outcome is that the market "zig zags" for the next 12 to 18 months, meaning there is no rush to buy shares, which may even be cheaper in a month or two.

The head of core equities at Colonial First State, Martin Littler, says the big capital raisings by companies (more than $90 billion during the past year) have helped the rally gain momentum. Investors who participated in the share issues, which were offered at deep discounts, are sitting on windfall profits.

Littler believes the balance sheets of the biggest 100 companies have now been repaired, with debt levels much lower than before the crisis. But while companies have been cutting their costs, their revenues have not yet returned to growth.

"To be back in comfortable territory we really need people to be spending," he says. Still, the Australian sharemarket's 40 per cent rebound since March is the biggest and quickest in history. Most analysts say the March low, when the S&P/ASX 200 hit 3150, will almost certainly prove to be the low of the cycle. But investors would be wrong to assume that the next 40 per cent will be as easy.

The chief economist at CommSec, Craig James, says there are good reasons for investors to be encouraged by recent economic data but adds that "investors must be on guard against over-exuberance and continue to maintain diversified portfolios". The market has to rise another 60 per cent before it revisits its all-time high of 6800 points, reached in November 2007. James expects Australian shares to end the year about where they are now (4400 points) and to move a little higher by the middle of next year. Other economists have similar expectations.

The best time for bargain hunting was at the end of last year and the very beginning of this year as the share prices of big banks and miners were being priced for Armageddon. Analysts and funds managers say investors need to be very cautious but some opportunities can be identified. It is important for investors not to get too preoccupied with the broad market indices but to assess the prospects of individual stocks.

The global financial crisis started out as a banking crisis. The share prices of US banks fell 90 per cent during the crisis and Australian bank share prices fell 60 per cent. Financial stocks have enjoyed a good recovery since March. But Warnes of Morningstar is not expecting the share price of the Commonwealth Bank ($47 at time of writing) to soon regain its high of $62 or Macquarie Bank (almost $50) to revisit its all-time high of almost $100 a share. It will likely take years to regain those highs.

BANKS' BEST BET

"I am surprised that we have had such as strong rebound, given the facts," a senior client adviser with Austock Securities, Michael Heffernan, says. But he sees value in the big banks for long-term investors. "I like all of the big banks, where the scope for growth is good as the competition has been mostly eliminated," he says. "But if I had to go for one, I would go for CBA. CBA has a fantastic franchise."

Commonwealth Bank, the biggest home loan-lender and an economic bellwether, last week reported a cash profit of $4.41 billion for the year ended June 30, a fall of 7 per cent on the previous financial year.

The bank also announced it would cut its second-half dividend payment by 25 per cent. Analysts, however, regarded it as a reasonable result given the current economic backdrop.

The chief executive of research group and fund manager Lincoln Indicators, Elio D'Amato, says the pace of recovery since March is not sustainable. But Australia is doing "pretty well" and D'Amato is comfortable with where share prices are at the moment. His preferred big bank pick is Commonwealth Bank.

A private client adviser with Baillieu Stockbroking, Colin Cruickshank, says investors should try to look a bit further out, to when the recovery is under way.

He says investors could do well by getting set in selected cyclical stocks. Cruickshank says building materials supplier CSR is particularly well placed to profit from the recovery. CSR owns Bradford Insulation and is benefiting from the Government's rebate for ceiling insulation. Cruickshank also likes the building materials supplier Boral and the construction company Leighton Holdings. These stocks would benefit even if the recovery were a "normal" one. But the Government's spending on schools and infrastructure will only enhance the companies' growth prospects, Cruickshank says.

RESOURCES KEEP ON

Resources stocks have also come back very strongly, featuring prominently among the best performers of the market since March.

The co-founder of small companies manager Eley Griffiths Group, Brian Eley, says some of the smaller resources stocks have almost certainly run too far. "Many just can't believe that they have received a get-out-of-jail card, as many have doubled or tripled in the last three months," Eley says.

Nevertheless, Eley is a believer in Chinese economic recovery and expects developed economies to recover during the next two years.

He says selected resources stocks are likely to do particularly well. Eley prefers producers of commodities to explorers. He favours the mid-cap Whitehaven Coal. Among the smaller companies, he likes the nickel sulphide producer Panoramic Resources, copper producer Equinox Minerals and the manganese ore producer and processor OM Holdings. Among the smaller resources stocks, D'Amato favours Beach Petroleum, a profitable oil producer with a strong program of exploration.

SMALLER-CAP OPPORTUNITIES

"I know that a lot of conservative investors focus on blue chips but they shouldn't restrict themselves completely to the biggest stocks," D'Amato says.

He says there are healthy stocks with good prospects within the mid-sized and smaller-companies sectors.

He likes sleep-management company ResMed, which, he says, is a "great business". He also favours the business-software company Reckon Group, which reported strong profit growth last week and has made some good acquisitions.

Among the smaller companies, Eley likes financial services information provider IRESS Market Technology, internet service provider iiNET and financial services company WHK Group.

Companies report improving outlook

Barely halfway through the company profit reporting season, a fairly positive picture is emerging.

That means the massive rally on the sharemarket could have some way to go.

The co-founder of small companies manager Eley Griffiths Group, Brian Eley, says: "Even relatively poor results have been generally well received because the outlook is improving." He says most companies are seeing better times ahead.

Reflecting the fact that Australia has weathered the global economic crisis better than other developed countries, domestically-focused companies have tended to do best.

Commonwealth Bank announced a relatively small decrease in earnings (7 per cent) as it benefited from less competition and higher margins.

Telstra announced a 10.3 per cent rise in annual net profit with strong revenue growth and will maintain its dividend for 2008-09.

Electronics retailer JB Hi-Fi posted a 45 per cent increase in full-year net profit for 2009. It expects a 20 per cent growth in sales in 2009-10.

BHP Billiton, exposed to the global economy, announced a 30 per cent fall in its underlying full-year profit. The world's biggest miner says a recovery in the global economy is still some way off.

Sleep management company ResMed booked a 33 per cent rise in profits for the year to June 30, 2009.

Beverages company Coca-Cola Amatil is forecasting profit growth of almost 10 per cent for the second half of calendar 2009, assuming current economic conditions prevail.

The experts' top five picks

John Kessell, head of investment research, Aegis Equities Research

* Woolworths offers good value. Well-managed and strong balance sheet. An oversold, high-quality, large-cap cyclical. Expected to deliver above-average earnings-per-share growth.

* CSL is a biopharmaceutical researcher and maker. It has a global market in the recession-proof blood plasma business. It will benefit from increased government spending on health care.

* Billabong has a portfolio of quality brands with proven management. Until economic sentiment in the US and Europe improves, sentiment will run against the stock of the clothes maker and retailer. It has an opportunity to acquire a high-quality company at reasonable prices.

* Woodside has high-quality oil and gas assets and is a leader in liquefied natural gas (LNG). Future LNG projects provide good growth potential.

Elio D'Amato, chief executive, Lincoln Indicators

* Wesfarmers is starting to get its act together with Coles. The stock is on a yield of just more than 7 per cent, though this is expected to come down a little.

* Commonwealth Bank of Australia is a standout. D'Amato says the bank's guarded guidance at last week's profit results has not fooled many because, operationally, the big banks have not had it so good for two decades. The bank picked up a bargain in BankWest (see Hot Stock, page 8).

* Coca-Cola Amatil offers defensive earnings with good cash flows and fundamental strength.

* BHP Billiton provides the potential upside from the mining boom among the big miners and is a core holding for even the most conservative sharemarket investor.

CSL is a rock-solid business. It is trading at a historically low price-to-earnings ratio with very strong growth prospects.

Michael Heffernan, senior client adviser, Austock Securities

* Commonwealth Bank of Australia is a fantastic franchise, which, he says, is hard to go past.

* Energy Resources of Australia is one of the largest uranium producers in the world, providing 10 per cent of the world's uranium production. It is a great stock and future earnings are expected to be very strong.

* Rio Tinto is preferred over BHP Billiton. Steel has no substitute and China has embarked on a massive infrastructure-building program.

* Reject Shop is a mid-sized stock with very good sharemarket fundamentals and a strong return on equity. Management of its stores is good and it has national reach.

* InvoCare owns and operates funeral homes, cemeteries and crematoria around Australia. We all have to die sometime. It is a middle-to-small stock but, like Reject Shop, Heffernan does not consider it to be a speculative play. It is a very good company, though its debt levels are a little high.