INVESTORS looking to optimise their share market returns in the next six months should look to value stocks given the prevailing economic conditions, which will create a difficult environment for growth stocks.
And while some significantly under-valued stock–specific opportunities are now emerging among leading growth stocks — such as Westfield Holdings, now trading at a 20 per cent discount to discount-cash flow valuations — in aggregate, growth stocks are likely to under-perform value stocks during the remainder of the calendar year for two main reasons.
Firstly, bond rates are likely to rise, which will have a greater negative impact on the valuations of long-duration PE (price to earnings ratio) stocks than on short-duration low PE stocks.
The second reason is Australia’s strong recent economic growth, which looks set to continue at least in the short-term, and the associated increase in the number of growth stocks that investors can now choose from.
With more and more stocks now delivering double-digit earnings growth, investors have become less willing to pay a premium for stocks that deliver ‘earnings certainty’ — effectively narrowing the gap between high and low PE stocks further.
Having said that, it would be unrealistic to expect value stocks to outperform growth stocks in 2002/03 to the magnitude that they have in 2001/02.
Banks and property trusts stand out as significantly over-valued relative to other sectors. Investors seeking earnings certainty have pushed the property trust sector to a record 19 per cent premium to net asset values.
Meanwhile, the banking sector is now trading at a five per cent premium to discount-cash flow valuations, compared to a 12 per cent discount for the All Industrials, excluding banks and Newscorp.
New investors should hold off committing funds to listed property investments until unsustainable premiums to net tangible assets decline. In the meantime, existing investors should maintain a neutral exposure to property in the short-term as defensive risk characteristics counter-balance overvaluation.
Turning to international share markets, investors should trade with caution. Lonsec’s outlook for both the US currency and equity market over the next two quarters is negative. US dollar depreciation may prove a continuing trend for the next 18 months to two years, as global capital flows continue to shift away from US-denominated assets.
Despite substantial share price declines, US equity market valuations do not yet offer compelling value. And while the Dow Jones Index is now trading on an acceptable PE multiple of 18 times reported earnings, there remains considerable doubt over the veracity of reported earnings. Creative accounting has enabled US corporations to hide the true extent of their debt burdens using complex corporate structures.
So it comes as no surprise that investors are discounting share valuations where they are unable to ascertain the full extent of a company’s debts (post the Enron collapse) or the accuracy of their reported earnings and cash flows (post the WorldCom scandal).
The global capital market’s love affair with US dollar assets is finally dying. Foreign investors are no longer willing to ignore the ever-growing US current account deficit; fixed interest investors are no longer willing to ignore interest rate differentials (1.75 per cent in the US compared to 4.75 per cent in Australia and 5.75 per cent in NZ); and astute equity investors are avoiding US equities, where earnings expectations remain inflated and investor confidence has been seriously dented by recent corporate collapses.
Interestingly, while the Australian share market has closely followed the US market in the immediate aftermath of several recent major global economic and political shocks, the effect hasn’t been ongoing.
A look at the local share market’s performance six months down the track reveals that it is predominantly determined by its own investment fundamentals — namely earnings growth, valuations, and liquidity.
Markets are already starting to anticipate a broadening out of global economic activity, with Asian equity markets beginning to attract significant capital flows, placing them among the best performing investments.
Much of the recent recovery in Asian equity markets is due to an expectation of increasing global trade. In a similar vein, Australian stocks with exposure to global growth are likely to outperform domestic cyclical stocks.
Investors seeking international equity exposure should look to balanced funds and actively managed international funds that manage currency exposure.
John Watson is head ofequity research for Lonsdale Securities.
