Fair weather ahead?

The following views on the outlook for equities in 2007 may well undergo some changes over the next few weeks, as I am writing this in the middle of half-year reporting.

Once we have heard and analysed all the company announcements, any confidence — or lack of confidence — engendered by the reporting season could have a significant impact on the market for the remainder of the year.

However, at this stage, we believe there are several clear themes emerging for 2007.

As we all know, in recent years the Australian share market has been unable to do wrong, and investors who stayed in the market have reaped the benefits.

Last year was the fourth year in a row that the Australian equities market recorded double digit returns — up almost 25 per cent for the year.

So far in this bull market, only the 2004 calendar year result — just shy of 28 per cent — has been better.

Small and medium cap stocks continued to perform particularly well, with an average return of almost 30 per cent.

The market has continued to reach new heights, supported across a range of sectors, without any indication there may be a major downturn.

The corrections we have seen so far have been triggered by sector rotations rather than any significant change to the overall fundamentals of the market. Over the past six months these fundamentals have, if anything, improved, and the market has strengthened accordingly.

At this stage, we see no reason why the market shouldn’t continue to deliver good returns throughout 2007 and, perhaps, into 2008 as well.

As a result, our expectation is that the market will provide double digit returns this year. Of course, this is barring any unforeseen shocks, and assumes that consumer spending remains strong, that global growth continues to run above trend, and that inflation gradually returns to more comfortable levels.

Most indicators, particularly the current global picture, support this view.

Global growth is expected to remain at an above-trend rate of about 5 per cent.

The world is currently enjoying its strongest period of economic prosperity since the early 1970s, driven almost exclusively by emerging economies in Asia, Europe and South America.

Gross domestic product (GDP) growth in ‘developed’ Europe and Japan is expected to be around 2 per cent in 2007, and about 2.5 per cent in the US, or less than half the global rate for the world’s major economies.

Despite this, the economic news from these regions has been mostly positive over the past couple of months, with growth expectations remaining steady or revised up, and inflation plateauing or starting to trend lower. The environment for equities in all of the major markets is positive.

A positive global backdrop for equities, particularly the US, will help provide the necessary stability for the Australian market to continue its growth.

At Platypus, we believe the consumer sector recovery in Australia that started last year will continue and, excluding the impact of the drought (which could take up to a full percentage point off GDP), a higher rate of economic growth is possible in 2007 and 2008 compared to the past 12 months.

It seems likely that inflation will ease back into the Reserve Bank’s 2-3 per cent comfort zone by the middle of the year.

However, the 25 per cent-plus annual returns that many investors have enjoyed during the equity bull market so far are unlikely to materialise in 2007.

We believe the market will return closer to 15 per cent, which is still a very healthy performance (and above long-term averages), but well below the levels previously experienced.

As a result, some advisers may need to manage client expectations for lower returns from their investment portfolio.

Market outlook

The February/March reporting season usually gives a good indication of where the market is heading.

Prior to the current reporting season, expectations for earnings were high, and most companies so far have announced reasonable results, which will continue to buoy the market.

We have been particularly impressed by the revenue growth reported by many companies for the six months to December.

This has been the key driver to upgrades in profit growth, and gives us confidence that strong earnings growth can continue into 2008.

Despite some comments by professional investors that valuations are too high, we would respectfully point out that on a price/earnings basis at least, valuations remain around 10-year averages in Australia, and well below average in the major equity markets.

There are, as always, pockets of overvaluation to avoid. But we believe there are still opportunities in several sectors where companies are trading below fair value.

We expect that the demand for shares will remain strong, driven by good earnings, reasonable valuations and a high level of corporate activity.

Superannuation funds are being driven by changes to superannuation tax concessions, which are encouraging Australians to make more, and bigger, voluntary contributions, and equity offerings are likely to continue to be snapped up very quickly. Demand continues to keep pace with, and even outstrip, supply.

Sector outlook

Following a year where the consumer sectors in particular performed well, this year investors should reap solid returns from those market sectors that performed poorly last year.

For instance, the demand for commodities from China has not changed, and increased domestic production there has not altered the current imbalance of demand over supply.

The major mining companies Rio Tinto and BHP Billiton, look in our opinion, compelling on a valuation perspective. We believe that the extent of the undervaluation means that these two major commodity stocks will deliver substantial returns this year, even if base metal prices continue to soften or go sideways.

History has shown that both these companies can achieve good returns in periods when their major commodities are declining in price.

We also feel strongly that Australia’s global healthcare companies (CSL, Resmed, Cochlear and Sonic) will benefit from the strong investment climate we expect in 2007. As a group, they only performed slightly better than the market last year, despite having superior short and long-term earnings profiles. We would not be surprised to see some valuation expansion in these stocks (as well as earnings-driven performance) over the course of the year.

Overall, wealth management companies should perform strongly again this year.

As already mentioned, investors are looking at ways to get more money into superannuation funds, so we see diversified financial companies as being very attractive at the moment from an earnings and long-term valuation perspective.

On the other hand, some sectors that produced good returns in 2006 are unlikely to perform as well this year.

We are struggling to see value in property trusts or utilities, despite the level of corporate interest in both these sectors.

These were two of the best performing sectors last year, with much of the performance driven by rises in valuation rather than earnings or distribution growth.

Similarly, retail stocks had a great 2006, outperforming the market by 5 per cent.

While a lot of this return was driven by earnings and earnings upgrades, there was also a material element of valuation expansion.

While we have not reduced our exposure to retail companies, it is a part of the portfolio that requires very close monitoring.

Retail stocks are no longer ‘cheap’, as they were 12 months ago, and an adverse change in the environment for consumer companies would herald a period of significant underperformance in these companies.

Market correction

Despite our positive outlook for the year, and our prediction of double digit returns over the course of 2007, we do believe that investors should be prepared for at least one market correction, and possibly two, at some point during 2007.

Any time the market moves up in a straight line — as it has done so far this year — there is a greater chance for a fall if there is an external shock.

The more buoyant the market, the larger the correction is likely to be. However, if it happens soon, it is likely to be short-lived in our view.

The most likely catalyst for a correction this year is the electoral cycle.

While the Federal election is some way off, recent polls have suggested there may be a change in government.

While we do not believe a Federal Labor Government would alter the outlook for the equity market, it could perhaps create enough uncertainty in investors’ minds to trigger a correction.

Impact for investors

So what does this mean for investors?

Overall, Australian equities are likely to remain the best-performing domestic asset class in 2007.

But, as we saw last year, when the large resource stocks fell out of favour, trying to get exposure to (or away from) the right sectors at the right time can have a big impact on performance.

In the short space of a calendar year, last year’s undervalued stock or sector can become this year’s hot (and ultimately over-valued) stock or sector.

2007 looks to be no different. The danger for investors lies in the fact that the market can be slow in picking up a big macro theme — such as the recovery in retail last year — but once it does pick it up the market quickly re-prices, and then overprices, the new investment theme.

By the time most personal investors have learnt about this, and decided to get in on the opportunity, the chances are that they are buying shares at the over-valued prices.

As always, we recommend that investors look for long-term opportunities rather than trying to jump onto the latest trend.

Stock tips

At Platypus, we focus on companies with long-term growth potential without any regard to the index. Our portfolio typically has a small-cap bias, which is driven purely by our focus on long-term potential, rather than any structural constraints we place on the portfolio.

We look for shares that we believe have been undervalued by the stock market, based on their track record of earnings and dividend growth, and what we see for their future earnings.

We believe that this seeking of value, rather than following sectors that are currently in favour, is the approach that will pay off for investors in 2007.

As I say, in every sector there will be pockets of opportunity. It is picking those stocks that will make a difference in 2007.

Some of the stocks we recommend keeping an eye on in 2007 are:

1. Macquarie Bank. The stock remains cheap relative to its own valuation history despite a 40 per cent rise since August, and the consensus earnings estimates for 2008 and 2009 are, in our opinion, low. We expect the share price to move well beyond $100 this year.

2. CSL. The company continues to perform beyond the market’s expectations and earnings should double over the next five years. CSL is another company whose share price is likely to breach the $100 mark in 2007.

3. BHP Billiton. As mentioned previously, we believe BHP will rise even if commodity prices keep falling. We expect commodity prices to stabilise this year at elevated levels, which should increase investor confidence in the duration of this commodity cycle.

Our share price target for 2007 is $40.

What the future holds

It’s probably a bit dangerous to take a firm view and predict what might happen next year, as there are so many potential influences.

But a couple of themes should continue.

For example, we would expect the strong environment for companies geared to the superannuation industry to continue in 2008.

The only other industry we can think of that has a long-term growth rate comparable to money management and superannuation in Australia is healthcare.

Investors in natural resource stocks should keep an eye on what is happening in developing economies such as Brazil, Russia, India and China.

While we are hopeful they will pick up any slack that would result from a slowdown in the mature northern hemisphere economies, we are also aware that emerging economies are more volatile than developed ones.

China in particular might experience some economic volatility next year around the summer Olympics.

Historically, the Olympics have not been an economic boon for the host nation, and many host countries have recorded a period of negative growth around or just after the event — Australia posted one of its rare quarters of contraction in the 2000 Olympics year.

While we would not expect China to suffer a period of contraction in 2008, we would not be surprised to see more volatile economic data.

The other big issue for 2008 is, of course, the US Presidential election.

Historically the last two years of a Presidential term have been associated with better stock market returns than the first two, which theoretically bodes well for this year and next in both the US and domestically.

Donald Williams is the chief investment officer of Platypus Asset Management, a high conviction Australian equities fund manager that is a joint venture with Australian Unity Investments.