Australian Equities: Where did all the love go?

After the horrible performance of the Australian share market in 2008, everyone from big institutions to retail investors is looking for some promise of improved conditions, but they may be waiting a while yet.

Although Aberdeen Asset Management’s head of Australian equities, Mark Daniels, is hopeful things will “not be as torrid as last year”, he expects to see little change in the performance of Australian equities until later in the year.

“Until the middle of this year or the next reporting season after August, there won’t be any new green shoots here or anywhere else,” he said. “There are no major catalysts to change the market.”

However, sideways movements may be a little easier on investors’ nerves than last year’s wild volatility and dramatic slump.

In 2008, the S&P/ASX 200 Accumulation Index returned -38.4 per cent for the calendar year. While the index returned -0.3 per cent in December, its 12-month performance to January 30 remained a dismal -34.0 per cent.

Frozen credit and economic gloom

The pounding of the Australian equities market has given way to ongoing concerns about the state of the global economy and whether or not the local economy will join the slide into recession.

However, stabilisation of credit markets and the availability of lending appear to be the key to an eventual rebound in equity markets.

As Dr Susan Gosling, an investment manager with MLC Investment Management noted in her February Investment Update: “A sustainable rally in risk assets remains unlikely until there is normalisation in credit markets, because this is what’s required to stabilise the real economy.

“Resumption of the credit creation process is the single most important foundation on which the recovery will be built — and this will be the most important positive signal for risk assets.”

If this is the case, there may be some cause for optimism, according to Schroders Investment Management head of Australian equities Martin Conlon.

“Tentative signs that credit markets are beginning to function again, will hopefully ease the currently intense pressure on companies from bankers belatedly tightening credit standards and hoarding capital,” he said.

This year’s corporate reporting season will also be extremely telling and is the most important disclosure period in over 70 years, according to Lincoln Indicators chief executive, Elio D’Amato.

With ongoing deleveraging and asset write-downs, there is now a much stronger focus on the health of a company’s financial accounts than in the recent past, he said.

“Knowing the financial health of a business is the most important rule of successful investing.”

Aberdeen is also looking closely at the financial performance indicators provided by companies this reporting season, according to Daniels.

He said the firm is focusing on areas such as the level of dividends and payout ratios, capital management issues such as when corporate refinancings are due, and whether debt has been decreased.

“In larger companies we are looking at the impact period-on-period of a strong Australian to US dollar, which is now much weaker.”

Outlook for Australian equities

Despite ongoing concern about the local economy and the health of many companies, investment experts believe equity markets have priced in a lot of the bad news and should recover on expectations of improved corporate profitability.

As Andrew Pease, Australasian investment strategist with Russell Investments, pointed out in a recent research note, local shares “look good value after falling 50 per cent from their peak”.

He said the current dividend yield of around 6.5 per cent in mid-January indicated the underlying value in the local market was at its highest in over 30 years.

“The dividend yield is now above the long-term government bond yield for the first time since at least the late 1960s. The gap is even higher when franking credits are included,” Pease noted.

While both dividends and profits are under pressure, he said the “positive spread between the dividend yield and the bond yield is yet another indicator suggesting that investors have already priced a lot of bad profit news into share values”.

Conlon agreed there is reason to be optimistic.

“We believe we are moving into a period in which significant opportunity is available for those willing to embrace risk sensibly, as others become increasingly fearful,” he said.

“In the Australian

market, we believe there is good reason to move forward with a greater degree of optimism.”

Tim Farrelly from asset allocation consulting firm Farrelly’s is also positive.

“The returns are very likely to be excellent from here on in. They [shares] are half the price they were compared to two years ago,” he said.

“Returns are more attractive than two years ago but now no-one wants to buy. It’s not logical.”

He believes the current situation, where many investors are waiting to see what happens, is “a huge game of chicken” and one that may cost advisers and their clients dearly if they get their timing wrong.

D’Amato agrees investors are not looking through the current negativity.

“At the moment, no-one can clear off the haze of despair. There is a pure lack of confidence in the market.”

More volatility ahead?

Despite the good value, some commentators remain concerned there could be more trouble ahead.

As Gosling noted: “While many assets … undoubtedly offer excellent value, the fundamentals are still deteriorating and we can’t be sure there won’t be more forced selling. Calendar 2009 looks set to be a volatile year as expectations shift with the flow of news.”

Questions also remain about prices, she said.

“Equity markets have not priced in as adverse a scenario as debt markets and there could be further declines.”

AMP Capital Investors head of investment strategy and chief economist Dr Shane Oliver has similar short-term concerns.

At the start of February, he noted the difficult global economic and profit outlook meant “falls to new lows are a very high risk for shares over the next few months”. However, he went on to say on a one-year plus view, shares “should provide solid gains”.

Oliver also pointed out the policy response to the financial crisis was likely to result in a global recovery later this year or through 2010 and “shares will lead this as they normally do”.

D’Amato agreed there is likely to be at least three to six months of extreme volatility as more bad economic news appears, but “the market is a forward-looking beast and it will turn”.

“The market will not go back to November 2007, but it will stabilise and return to a more normal pattern,” he said.

Value will lead you back

Despite the current nerves, commentators are more positive about the prospects for large cap stocks than those at the other end of the scale, particularly given that the top 10 stocks account for over half the S&P/ASX 200.

“The index mirrors the large caps’ performance, so when they turn up so will it,” D’Amato pointed out.

“Large caps will lead as they are seen as where the value is and where investor interest will be first.”

Russell Investment’s Pease is not so sure. On his figures, small caps underperformed large caps by 16 percentage points during 2008, with the Small Ords falling 53 per cent compared to a 37 per cent decline in the ASX 100.

“Small caps are now trading at a 22 per cent PE ratio discount to large caps. This suggests that small caps should outperform when equities rebound,” he said.

D’Amato is also enthusiastic about small caps, although he noted they faced ongoing pressure because of restricted access to finance.

“Small caps are really offering incredible value at the moment, but they only have one revenue stream and that adds risk, so it makes us wary at the moment … But it will be one hell of a rally in small caps when confidence returns,” he said.

According to Aberdeen’s Daniels, one advantage for small caps is their ability to move quickly.

“Small caps can change their business model more easily if needed and they are more nimble than large caps. However, they are not likely to lead the market up as that can only come from large cap stocks.”

Listed property trusts — the former favourites of advisers and their clients — seem likely to remain in the doghouse for the foreseeable future.

While the LPT index has fallen 66 per cent from its mid-2007 peak and is now 600 basis points above the 10-year bond yield, Pease noted fears about property revaluations and high gearing levels (32 per cent) are likely to hold the sector back, despite it appearing to offer “significant value”.

Looking for opportunities

According to Conlon, the current trend at the stock level in Australian equities can be summarised in one word: defensive.

“Safety continues to be sought in stocks expected to weather the economic storm.”

He believes investors have become overwhelmingly concerned with risk and debt rather than looking at potential corporate earnings.

“Businesses which have been savaged by financing concerns (including banks) together with those which have been at the centre of investor panic on earnings are most likely to spur a recovery,” Conlon said.

The flood of government money into the Australian economy will have an impact on particular market sectors. For example, Lincoln Indicators expects infrastructure stocks to benefit from increased government spending.

“The Federal Government’s stimulus plan will inject cash into the economy and includes implementing new infrastructure projects. This will have a positive impact on engineering and construction companies,” D’Amato noted.

Conlon believes investors need to look to sectors that can “deliver future productivity gain and genuinely enhance economic growth”.

Companies offering competitive differentiation and innovation are more likely to succeed going forward than those seeking only volume growth, he said.

“Sectors such as technology, healthcare and others, in which Australia can produce high quality, differentiated products which produce better returns per unit of capital than their global peers, should always be the first port of call for investors.”

Lincoln also favours healthcare stocks (eg, CSL and Sonic Healthcare), but likes consumer staples (eg, Woolworths and The Reject Shop) as well.

Investors looking for a contrarian position should look to stocks — such as Boral — that will provide the products necessary to roll out the stimulus infrastructure, D’Amato said.

Time to prove skills

When it comes to Australian equities managed funds, the picture has been grim, with many funds experiencing significant outflows as investors lose faith with underperforming active managers. However, institutional consultants such as Mercer are continuing to advocate active management.

As Simon Eagleton, head of Mercer’s investment consulting business in Australia and New Zealand noted recently: “Active managers will continue to be important in adding value to investors’ portfolios”.

He pointed out the financial crisis was a particularly challenging environment for active managers and their recent underperformance did not mean they had suddenly become “incompetent”.

“Successful active managers are able to apply unique insights to markets and to dispassionately act on those insights,” Eagleton said.

“Mercer believes that high quality active managers will be faced with widespread opportunities to capture added value.

“Even if we allow ourselves to imagine for a moment that the markets will never return to ‘normal’ again, there will always be insightful and flexible active managers who are able to quickly develop means to exploit what inefficiencies there are in a new reality.”

In fact, Farrelly argued the current environment may be just the time when diversified funds reveal their worth.

“Now is not the time for concentrated portfolios of 10 or 15 stocks as we will lose people along the way,” he said.

He believes there is a strong argument for buying diversified funds or the index rather than trying to demonstrate stock selection skills.

D’Amato agreed this is the time for managers to prove themselves.

“It is not the equities market that should come under question but the manager of the money that should be questioned. Investors should be asking if they are the right manager for their money,” he said.

Advice for advisers

According to the experts, one suggestion for advisers is to consider recommending a dollar cost averaging strategy to clients.

“The argument for dollar cost averaging is more valuable now than previously due to cheaper prices,” Daniels noted.

Both D’Amato and Farrelly agreed it could be a good strategy, particularly given the current level of uncertainty.

“At these prices, do whatever is necessary to get clients set in the market,” Farrelly said. “Market timing is too hard but at the moment valuations are compelling.”

He suggests advisers get clients to slowly move into the market over the next six months so they can take advantage of the longer-term opportunities.

“Returns over seven to 10 years could be easily 10 per cent per annum,” Farrelly said.

“If the downturn is more serious and longer than expected, investors will still make similar returns as from cash.”

D’Amato believes a key tip for advisers is to “heed your own advice and remember markets have up cycles and down cycles”.

“If you believe companies will grow and create profits over the next 20 to 30 years then the share market remains worthwhile,” he said.