Diversification the key to equities success

Last year will undoubtedly go down as one of the more remarkable years for equity markets in recent memory. With volatility now more subdued and shares trading somewhere near 'fair value, Matthew Drennan explains what lies ahead for 2010. 

The initial P/E expansion in equity markets is finally completed.

Top line earnings growth is now required for the next step up in markets. Strong company profits on the back of cost cutting programs will no longer suffice, and as a result further rallies will need to be fuelled by sales growth.

Markets appear to be in a balance between profit taking and pent-up demand from investors waiting for pullbacks as a buying opportunity.

So pullbacks are likely to be quite short and shallow barring a serious unforseen shock. Equities should trade in a range over the next few months as recent gains are consolidated.

Thereafter, I would expect the Australian equity market to return about 12—15 per cent over 2010. The first real test will be the February reporting season.

With this is mind, I would like to focus on a couple of the investment mistakes that I believe are currently being made and a few opportunities that may arise for investors over 2010.

The first mistake is the obsession with inflation risks.

Part of the rationale for the three interest rate increases we have shouldered to date has been the bogeyman of inflation from a rapidly recovering economy.

Australia’s CPI is not signalling any imminent threat, and although our economy (along with most of Asia) is doing well, the rest of the developed world isn’t.

Sure there will be pockets of wage-driven inflation as the next leg of the resources boom kicks in, but this won’t affect much outside of WA.

So is this focus on inflation complete nonsense? Not entirely.

Historically, central banks have not targeted asset price bubbles as part of their inflation mandate, but this is a luxury we can no longer afford.

If you strip the global financial crisis down to its core, it was a disaster born out of an asset price bubble in US property and commercial debt markets fuelled by unsustainable amounts of leverage and a lack of supervision.

The seeds of the next asset price bubble may be being sown right now. Where? Well one possibility is in Asian equities. This is a perfect segue into another commonly held belief that I think is dangerous.

There is a perception that all strong economic growth in the next few years will come out of Asia, and that therefore this is the only investment opportunity that will generate strong returns.

This is simply not the case. I can think of at least four other trades likely to produce good financial returns in the next few years outside of Asia.

The most obvious is leveraging off the growth in China. Resources in Australia and South America are the most obvious example here and everyone is well onto this.

Next is the need for rare earths as the world moves inexorably towards a lower carbon economy. As the name implies, there is not a lot of this stuff around.

The simplest example is lithium. It is used in the batteries of hybrid cars such as the Toyota Prius. It is difficult to see how these types of vehicles are not a crucial intermediate technology while better solutions are being worked on.

Yet another investment angle is the usual upswing in merger and acquisition activity after any major economic dislocation.

Post-GFC examples of this abound. Take the joint bid of AMP and AXA for the Australian listed AXA Pacific Holdings.

The target stock was up 30 per cent on the day the initial bid was announced to the market. Not bad.

Not to mention the subsequent higher bid from the same pair and the counter offer put on the table by NAB, leaving investors with an impressive return over a very short period of time.

My final source of strong expected returns comes from the Bradbury effect.

Just like the Australian speed skater who snatched Olympic gold when his competitors fell over on the last lap, many companies are benefiting from the collapse (or exit) of formerly fierce competitors. The Australian banks spring to mind in this regard.

So although Asia undoubtedly offers some fantastic opportunities, relying solely on the strength of their equity markets to provide strong returns for extended periods of time could well prove to be a very dangerous game.

If something goes wrong, there will be a lot of money heading for a very small door at the same time. A more diversified strategy is likely to yield better long-term outcomes.

Matthew Drennan is general manager, investments at Zurich Financial Services.