Australian equities - swings and roundabouts

A patchy economy and global turmoil has left the industry grappling with a jumpy share market and turning to active management in a bid to stave off negative returns. Benjamin Levy reports.

Any investor still waiting for a broad upswing in Australian equities will be left stranded. It isn’t coming.

The realisation that the mining sector is booming at the expense of everything else is causing Australian equities to behave as erratically as the economy.

Global economic turmoil is continuing to impact share market performance and weighs heavily on advisers, but despite its dangers, investors seem increasingly blasé about its potential impact.

Earnings downgrades across the share market are common, while a high Australian dollar has made sector investment impossible.

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Every other day fund managers release a statement claiming cautious optimism about Australian equities, as if they don’t want to seem too committed to it in case their predictions turn out to be completely off the mark.

But the erratic market is also creating opportunities for active management outperformance, and fund managers are switching to stock selection and boosting their research to take advantage of it. 

Patchy economy, patchy equities

The Australian economy is in less than perfect shape. Global economies are in turmoil, a high Australian dollar is causing havoc with exporters, and the mining sector continues to boom in the west even as the retail sector grapples with empty shopping malls in the east.

This patchy economy is being reflected in the performance of the share market. Fund managers are avoiding whole sectors of the Australian Securities Exchange, while the earnings expectations of those companies that are still doing relatively well have dropped by nearly 60 per cent.

“While the market will perform relatively strongly this year, the main reason is that it’s off a very low base, and earnings expectations are very conservative,” Bennelong Australian Equities Partners chief executive Paul Cuddy says.

Domestic equities have already gained 7 per cent since last year, but that’s an easy enough return considering from where the share market is starting.

A patchy economy will also cause polarised performance inside sectors of the share market, according to Greencape Capital director Matt Ryland.

As the economy becomes more unstable, making good decisions is paramount, and those companies that are managed well will survive and prosper, while those that have structural issues, cultural issues or simply don’t have the talent to run the company, will struggle.

That makes it difficult for investors to invest funds into the share market with any clear idea of how it is going to perform overall in the next 12 months.

Financial planners are pessimistic. Investment Trends’ Adviser Product Needs Report found that advisers expect the value of the share market to increase by just 8 per cent during 2012.

That’s an even worse result than in previous years, when they expected a rise of 10 per cent for 2011 and 14 per cent for 2010.

Fund managers aren’t overly confident of a sudden improvement in the economy during the year, so investors should take claims of better earnings from some listed companies with a grain of salt.

“There are going to be lots of risks out there.

"There are a lot of stocks out there that even though earnings expectations have rebased, they’re still expecting strong second-half earnings growth numbers to justify the current valuations, and we think some of those are going to be tested,” Cuddy says.

Colonial First State (CFS) expects a mixed performance from Australian equities for the balance of the year.

Colonial has watched many listed companies who have been expecting good results downgrade their earnings.

Those earning downgrades were also released during the February reporting season, meaning that some of the analysts have downgraded earning forecasts for the next nine months, as well as factoring them in to company results.

Head of Australian equities core and senior investment specialist at CFS Global Asset Management Matthew Reynolds believes earnings expectations for many companies have been unrealistic.

“It’s taken some time for the analysts to accurately reflect the challenging business environment we currently have in Australia in their earnings estimates,” Reynolds says.

Colonial senior investment specialist Chris Robertson suggests that in an uncertain environment such as the one Australia is facing, analysts “struggle” to capture the full extent of the information in their forecasts. 

A high Australian dollar, frugal consumers, and the rising cost of raw materials all play a part in company earnings, and analysts tend to wait until company results are released before they see the full impact.

With company results coming out every quarter, that means a three-month wait until investors know with clarity how bad things are – a long time given the recent shaky performance of the share market.

There is no telling when funds will start flowing back to the sectors of the share market that are currently experiencing difficult conditions.

The retail sector and the export sector are being avoided like the plague, with funds instead being ploughed into resources, mining services, and health care. 

The stratified structure of the share market has contributed to some sectors being hit harder than others, according to van Eyk senior investment analyst Matthew Olsen.

“Some industries have done much better than others because their earnings haven’t been as affected by a high Australian dollar,” he says. 

Other sectors that rely more on overseas currency payments are also doing better than others. Listed tourism companies, companies that compete with imports, and the manufacturing sector are among those who are suffering. 

“Those companies that rely purely on exports are in a world of pain,” Cuddy says.

Data provided by Colonial highlights how difficult things are for equity investment.

Over the last 12 months to February this year, nine out of the 11 share market sectors shown suffered negative total returns.

Surprisingly, the materials sector, which includes resources, suffered the worst negative 12-month total return out of all sectors, at minus 18.85 per cent.

Consumer discretionary stocks, information technology and financials all suffered losses as well, at 15 per cent, 16 per cent and 12 per cent respectively.

Only telecommunications and utilities recorded positive returns over a 12-month period.

Time for action 

This erratic behaviour in the Australian share market has put active management in the driver’s seat.

“Particularly at times when you’re seeing high levels of volatility in the market, what that tends to do is create opportunities for astute investors,” Olsen says.

Investors should refrain from making sector bets in favour of stock picking, Ryland says.

“That’s a function of the patchiness of the economy,” he says.

Standard & Poor's (S&P) signalled to the market in late 2011 that fund managers should switch to an active management approach to bring dividends in the next year.

Compressed company valuations will give fund managers opportunities to buy quality shares at attractive prices, according to the research house. 

Many stocks which have been sold down heavily will also rally as volatility passes and their earning outlook improves.

“The volatile market conditions we are currently experiencing are generally very favourable to active management,” S&P Fund Services analyst James Gunn said.

Fidelity Asset Management also flagged a more activist approach to Australian equities at the end of last year.

Fidelity Australian Equities manager Paul Taylor encouraged investors to look for structural growth when choosing companies.

“There are several listed companies that are paying dividend yields that are well above that of bank term deposit rates and these will increasingly be in demand from investors seeking consistent income from the market,” he said.

Many companies are trading at discounts compared to historical share prices, and are even discounted compared to the earning stream of the cash flow they generate, according to Olsen.

Prime Value Asset Management expects small and mid-cap companies to be less influenced by global events and is touting their greater flexibility.

“Small and medium cap stocks are often the first movers in a recovery.

"We think these smaller stocks are reasonably well placed for 2012, as they often have greater flexibility in their operations and the ability to achieve in tough markets,” says Prime Value senior investment analyst Fiona Clark. 

Stock picking needs a strong stomach. There are opportunities to be found even in retail – a sector most people would rather avoid – if they look for the right company.

The kind of stocks suitable in an active management market are those companies with strong yields, good cash flow, and which won’t require releveraging to drive their growth.

Prime Value also places importance on the ability of companies to execute their business plans. 

A low-risk appetite can cause investors to flee to large cap companies for their perceived safety, but large cap companies are large and unwieldy, which can lead to underperformance.

Investors have to be prepared to bet on smaller, more flexible companies, even if they are naturally more susceptible to economic downturns. 

The top 20 to 30 companies don’t have the right risk-reward balance, according to Cuddy.

“We’ve been seeing a lot of opportunities for active management outside of the top 20 to 30 names,” Cuddy says.

For many fund managers, that performance is relative. Australian equities haven’t improved markedly, but the situation for other investments has gotten worse.

Interest rate cuts by the Reserve Bank and less competition from the banks on term deposits in recent quarters have meant that returns have come down, while at the same time stability in equities has improved slightly.

“Net return, they’ve improved in terms of their attractiveness relative to other asset classes over the last six months,” Ryland says.

Research

What active management needs in order to be successful is research, and lots of it.

There is a lot of high quality research being done in the industry, but that research is widely available to all investors, and fund managers need to consult as many sources as they can to gain an edge over their rivals, Olsen says.

To go above and beyond the competition, those managers who don’t use external consultants need to engage them, Olsen says.

Most fund managers insist that their research processes are robust enough to get the best returns possible.

Greencape verifies its research by talking with competitors, customers and suppliers, and sometimes industry bodies and regulators, to gain confidence and conviction in its stock selection. 

“We spend vast amounts of time tracking down information that can help in that verification process,” Ryland says.

Colonial’s internal analyst team is well-resourced, Reynolds says.

“We meet regularly with listed companies we invest in, but also the companies they compete with, their suppliers.

"We travel extensively overseas to review their overseas operations, and we take notice of what’s happening in other markets,” he says.

S&P has backed the research process of the funds management industry, singling out the quality of that research in a positive performance for the equities sector in October last year.

There are strong competitive forces at play in the Australian market, and a tough environment for retail flows is making fund managers plough money into their research process to get an extra return point over their rivals.

Some fund managers are boosting the quality of their research, or launching new Australian equities capabilities. 

AMP Capital appointed two analysts to its equities team last month in an attempt to combat staff turnover and keep its fundamental equities capability strong. The team now comprises 13 investment professionals. 

T. Rowe Price announced plans in June last year to launch an entirely new Australian equity division, with the aim of growing its non-US client base.

Part of the launch is to cover a gap in T. Rowe Price’s own research capabilities, which have never had a presence here. The research generated will feed into its global research platform. 

Investors are looking at the stability of listed companies, their risk framework and their debt levels, and unless fund managers are globally integrated with their research they won’t be able to cover those stocks sufficiently, said T. Rowe Price director for Australia and New Zealand Murray Brewer.

The launch of T. Rowe Price’s Australian equities division is a reflection of the attractiveness of the Australian share market to overseas investors, Olsen says.

The $1.3 trillion superannuation market is a key magnet for overseas managers.

“Capital always flows to where it’s achieving a good risk-adjusted return, and if overseas investors perceive Australia is a safe haven because we have a strong currency and strong performing industries, then they may feel that Australia is a safe place to invest,” Olsen says.

Global concerns

Australian investors’ approach to global events seems to be contradictory. They are closely watching overseas turmoil, but seem less and less concerned about its impact at the same time. 

“I think investors are acutely focused on what’s happening overseas,” says Cuddy.

But at the same time, investors are starting to ring-fence what’s happening in Europe, and the gathering momentum of the United States recovery as well as receding concerns about Chinese inflation means that investors can be a bit more confident about the future of equities, Cuddy says.

The key issue is whether Europe will impact on the earning power of Australian-listed companies, according to Cuddy.

“Unless you’re an exporter, earning power is becoming less and less reliant on Europe, and more reliant on emerging markets,” he says.

Many of the issues surrounding Europe have also been discussed ad nauseam, to the point where investors feel they have their heads around the issue and can therefore afford to go on investing regardless. 

Some fund managers are cautiously optimistic about the future performance of equities, and claim global concerns won’t be too much of an impediment.

Clark admits that while market market volatility is likely to be a “fact of life” for equity investors through the year, it appeared that negativity surrounding global issues had already been priced into Australian equities.

Dividend yields are still very attractive, Clark says.

Investor sentiment needs to strengthen before funds start flowing back into equities, according to Robertson.

While the news coming out of Europe continues to weigh on investor sentiment, funds will continue to wait on the sidelines – but not for long. 

Reynolds says that the impact from Europe on investors will begin to fade throughout the year. 

“In the near term, we’ll continue to have some of the uncertainty surrounding Europe and Greece in particular impacting Australian equities, and I suspect that will fade,” he says.

The strength of market valuations should help. The equity market is trading on an 11 times price-to-earning ratio, so from a value perspective, it looks reasonably valued, while dividends are looking strong compared to bank bills.

But one has to wonder how much of that optimism is hope rather than considered analysis.

A survey of investment companies associated with the Financial Services Council has shown that most chief investment officers consider the European debt crisis to be the biggest risk factor impacting returns in the next 12 months. CIO sentiment has fallen since last year.

According to van Eyk head of research John O’Brien, investors may be underestimating how much headwinds overseas impact markets here. 

In a statement released by the research house early this year, O’Brien noted that while equities were still at attractive valuations, markets were almost certainly underestimating the same risks as in 2011.

“Investors are likely underplaying the potential for political and economic turmoil to damage markets and other threats like a potential breakout in inflation,” van Eyk said. 

Shallow downturn, shallow upswing

The irregular performance of Australian equities has been exacerbated by a shallow upswing in the share market, mirroring the shallow downturn of three years ago.

A factor of the strength of our economy, it has left investors here at a disadvantage when compared to the massive upswings investors have enjoyed overseas. 

In the recent US market rally, the S&P500 rallied approximately 20 per cent, while Australia rallied by only half that, according to Ryland.

However, the shallow upswing in markets will only lead to more active management in a bid to boost those returns.

“We seek to add value over and above the Australian equities index, and we will rely upon a stock selection, on a stock-by- stock basis, to do so,” Reynolds says.

Stock selection will be very important for generating investment performance, he says.

Australian equities can also cater to those investors who are still wary and looking at income generation rather than growth.

A large component of share market returns in Australia are franked dividends, which are favourable to income-seeking investors, Ryland says.

In the current risk-averse environment, that should boost investment in equities, even if their value upswing isn’t as steep as investors would like. 

Some fund managers believe that the shallow upswing can be explained by the defensive structure of the ASX.

The Australian share market is made up largely of banks, resource stocks and property trusts, which are more defensive stocks and more likely to perform in a more stable manner.

The US share market, on the other hand, is much more broadly based, with exposures to tech stocks, and a smaller property trust market.

That natural structure is going to lead to less upside in the Australian market, while share markets overseas gain value rapidly.

“There’s going to be less upside just by the composition of our index,” says Ryland. 

Reynolds believes Australia’s strong regulatory environment is responsible for the shallowness of the downturn here and its subsequent upswing.

By contrast, a weaker regulatory environment overseas would account for a much greater performance differential.

Fidelity Worldwide investment portfolio manager Kate Howitt believes the flexibility of our economy and strength of the large banks will eventually re-assert itself.

Historically, the trade-off between the mining sector and the household-driven sector has provided stability and growth to Australia’s gross domestic product.

Once growth in mining starts to fade, Australia will have an easing of monetary policy and a rebound in other sectors of the economy, Howitt said. 

Australian banks are some of the strongest in the world, corporate gearing is at 30 year lows, and earnings are at below-cycle peaks, with reasonable valuations, yield, and solid fundamentals. 

“These factors suggest it may not be too long until we are back to 2009 when there was a greater risk to not holding equities,” she said.