Value stocks in a cooling economy

With economic conditions weakening, investors should be looking even harder at undervalued equities with growth potential.

Summary: The latest mini-budget underscored a deterioration in economic conditions within Australia, including a sharp blow-out in the nation’s deficit. Although not dire, conditions point to a weaker outlook. A rise in the Australian sharemarket is more likely to be fuelled by the flow-on effects of low interest rates than underlying core earnings growth.
Key take-out: Given the overall outlook, investors in the current period should focus on companies trading at reasonable discounts to intrinsic value and not try to buy growth that will not likely occur.
Key beneficiaries: General investors. Category: Growth.

The calling of the election last weekend knocks down one unknown for markets. There will be no tortuous delay until November. The next government will be in place by mid-September.

Whoever is elected as the new government will be confronted with a significant fiscal policy problem. The release of the “mini-budget” last Friday confirmed a sharp deterioration in the current year budget and that of next year. After I scan the new budget forecasts below, I will draw some conclusions for the Australian equity market.

The fiscal deficit for 2013-14 that was forecast in the May budget was $18.1 billion, or 1.2% of GDP. The new forecast is $30.1 billion, or 1.9% of GDP.

The reasons for this sharp deterioration are muddied by conflicting statements and tables. The Treasurer claimed that Australia is suddenly confronted by an economic transition period. He rightly claims this involves the end of the resources capital investment cycle, but he wrongly claims that it is the end of growth emanating from China. Indeed the forecasts in the Budget Statement for China suggests growth of 7.25% per annum for the next three years. If anything, the forecasts are way too low for Japan, which is our second largest trading partner. Economic growth in Japan is likely to reach 3% in 2013.

The terms trade have and are deteriorating from historic highs. However, the negative effect from this is being tempered by the fall in the $A and the increased export volumes of our major commodities. Consequently, economic growth is not forecast to crash to recession levels but to decline to levels where unemployment begins to lift.

The confusion with the statement of the Treasurer is that the transition had been forecast by the equity market for at least the last 12 months. The awarding of resource capital investment contracts had peaked and the forward forecasts of order books has been under constant decline. It is thus extraordinary that Treasury and indeed the Treasurer did not see these events.

The other ominous effect of the increasing deficit is the unrelenting lift in the value of outstanding Australian Commonwealth bonds. The forecast is that it will at least peak at $370 billion (in 2016-17) from the current level of circa $270 billion. That is an increase of $100 billion over three years. The level was just $50 billion in 2007.

With more debt there is more interest to be paid. The government cash flow statement attached to the mini-budget forecasts the following net interest payments and tax receipts by the Commonwealth (Figure 5):

Figure 5. Australian Government net interest payments and taxation receipts

Net Interest

Cash Tax Receipts


$8.4 billion

$348 billion


$9.5 billion

$367 billion


$11.5 billion

$398 billion

Source: The Commonwealth of Australia

So when I look at the above statistics and forecasts I see a substantial lift in projected tax receipts despite a projected lift in unemployment and sub-par growth (i.e. below 3%). Meanwhile the debt burden is entrenched and the resultant interest costs are highly dependent upon a belief that bond yields will not lift dramatically. Indeed, the growing interest component of the deficit suggests that Australia will struggle to balance its budget without a major tax overhaul. Investors should thus assume that nothing is sacrosanct with taxation and that GST and superannuation remain the obvious targets for adjustment.

Outlook for market and companies presenting as value

There are some market commentators who are presenting arguments that the Australian market will rally by 20% from current levels in the next six months.

I hope they are right but I can see no justification for such enthusiasm, except perhaps if there is a further substantial fall in the $A. This latter point may well be justifiable from my analysis of the budget, but it must be tempered by the tepid growth flowing from Europe and the USA. Australia may have a slowing growth outlook, but it is not as bad as Europe and ours is still higher than the projected growth of the USA.

Rather, I suspect that the short-term economic outlook, possibly not fully captured by the budget forecasts, is actually quite disturbing. Indeed, the forecasts for the budget going out two and three years do suggest that Treasury has recommended that fiscal tightening be undertaken with a higher tax regime. Concurrent Commonwealth tax cuts suggest a contractionary fiscal outlook that will depress economic activity. If there is a lift in the Australian market then it will not be supported by earnings growth but be based on low interest rates and much hope.

Given this I would suggest that investors in the current period focus on companies that are trading at reasonable discounts to intrinsic value and not try to buy growth that will not likely occur.


The “StocksInValue” filter (Figure 6) of this week shows the best 10 lower-risk companies that present in the market as value.

When I review my growth portfolio I constantly review this table to identify new investment opportunities. So when I consider a possible new growth portfolio entrant from the above list in terms of the economic outlook presented in the budget, I draw the following observations with the following six companies:

Fantastic Holdings Limited – presenting as value with a reasonable yield. However, the company is not likely to benefit from any lift in consumer sentiment before Christmas. Growth in value at present is subdued and thus a bigger discount to value is required.

Monadelphous Group Limited – presents as good value but with a most uncertain outlook. The 12/13 result will be good and so investors need to examine the outlook statement presented in a few weeks. The budget notes the decline in resource capital investment cycle. I am sure Monadelphous foresaw this long ago and has contingency plans in place.

Reckon Limited – is trading at fair value and the current market predictions are for reasonable profit growth and continuing share buybacks. The budget outlook does not present a solid business case for Reckon, which depends on small business growth.

Fleetwood Corporation Limited – is absolutely at the epicentre of the slowing resource capital investment cycle. At this point Fleetwood offers limited short-term potential for value recovery from resources. However, a sustained currency devaluation or a major uplift in its caravan business could turn things around.  The budget to my eye suggests a weakening $A and increased local tourism by an aging, wealthy retirement sector over the next few years.

Metcash Limited – is fair value with growth inhibited by its weak competitive position. A slowing economy may suggest that basic food retailers could become attractive, but to my eye Woolworths is a far superior business.

National Australia Bank Limited – presents as the cheapest of the banks, but with a track record of disappointments. For yield investors there remains merit in its shares, but in terms of quality of business both CBA and WBC have better performance metrics.

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at

Clime Growth Portfolio Statistics

Return since June 30, 2013: 5.51%

Returns since Inception (April 19, 2012): 24.09%

Average Yield: 6.28%

Start Value: $141,128.64

Current Value: $148,908.13

Dividends accrued since June 30, 2013: $0.00

Clime Growth Portfolio - Prices as at close on 6th August 2013
FY14 (f)
GU Yield
BHP BillitonBHP $31.37 $35.624.97% $48.2035.32%
Commonwealth BankCBA $69.18 $73.537.44% $66.70-9.29%
WestpacWBC $28.88 $31.248.32% $30.94-0.96%
WoolworthsWOW $32.81 $33.116.04% $34.213.32%
The Reject ShopTRS $17.19 $16.544.15% $16.851.87%
BrickworksBKW $12.70 $11.995.00% $12.494.17%
McMillan ShakespeareMMS $16.18 $9.38N/a*
Mineral ResourcesMIN $8.25 $9.818.74% $14.1344.04%
Rio TintoRIO $52.37 $59.864.51% $81.7236.52%
SMS Management & Technology LimitedSMX $4.55 $5.217.40% $5.9113.44%
*MMS remains under review by StocksInValue analysts

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