Home grown values

It’s the Chinese year of the dog, and participants in the Australian share market are wondering where the canines lurk as talk of a correction ramps up.

But thanks to the positive lead from global share markets, strong corporate earnings and the commodities super cycle, the Aussie bourse has led 2006 with a record-breaking run in the first month.

Recent data from Plan for Life shows that huge inflows into Australian share-based funds continue unabated, partly due to a reconfirmation of a commodity-led rise.

Despite some gloomy predictions early in 2005 that the market would drop back to single-digit growth, the All Ords rose 16.18 per cent last year compared to 22.63 per cent in 2004.

Recent performance

But 75 per cent of the growth in equities occurred in the second half of the year and the winner stocks were mostly in the top 20, reflecting the institutional preference for the defensive.

The best performers were energy at 58.78 per cent and healthcare at 33.83.

The local ‘dog of the Dow’ was Telstra at -16.84 per cent and most things automotive at -51.74 per cent.

Large and mid caps fared well in 2005 — although not so much small caps as reflected in the Intersuisse Small Cap 150 index, which has 162 listed industrials valued between $25 million and $500 million. The index was overrun for the first time since 2001 by the All Ords and the ASX 200.

However, Macquarie Equities head of equity strategy Neale Goldston-Morris believes that mid caps remain expensive and “while there’s good stories around, most are struggling with increasing costs and a strong Aussie dollar. It’s a mixed story”.

The commodity market

The stellar rise of commodity prices had a significant effect on our economic fortunes and as prices continued to boom from the trough of 2000, so too has optimism for commodity-linked shares.

Of course, the danger now is that prices will collapse but, as Dr Susan Gosling, MLC’s general manager implemented consulting, points out in a recent paper, the difference this year is that the economic fundamentals are stronger. So, what next?

Goldston-Morris points out that in the current reporting season, the 20 per cent earning growth is largely concentrated in a dozen or so companies with BHP, Woodside and Rio contributing to half the earnings growth in the market.

“The next group down are Rinker, QBE, Brambles and Woollies. Banks are ticking over at around 10 per cent growth, so they’re doing well … but really, earnings momentum is narrowly based.”

The need for diversification

According to Mark Dutton, chief investment officer for AXA and Ipac, anyone with portfolio responsibility should take the time to rebalance, seek more diversification in all classes and look overseas.

“One theme is the notion of strategic versus tactical,” Dutton says.

“Investors in managed funds aim for diversified strategic exposure to markets and, mostly, funds will have a diversified portfolio with upside from some exposure to key factors driving the market, but they [the managers] won’t bet the house on it and they won’t run speculative positions,” he explains.

“There’s good reason for that; there’s other parts of the market you should never ignore and if it doesn’t work out well for a sector then there’s others that will. So you need the balance.

“There’s certainly a divided view on the extent to which we’re moving towards a structural change with China versus the cyclical response. There’s a risk that the market has lost sight of some of that, particularly in new production, infrastructure with supply responding to increased demand,” Dutton says.

“We’re seeing companies like BHP and Rio investing more. From an investor perspective, it’s hard to make a call. One should be wary about saying it’s different this time because there’s a supply response coming through,” he adds.

Dutton also notes that rebalancing is important in strong markets.

“If a market has produced between 20 and 30 per cent returns, then its weight in your strategy has increased and thus to keep to the long-term strategy means rebalancing from the expensive market to the less strong market.”

An optimistic outlook

Paul Taylor, head of Australian equities at Fidelity International, takes an historical view of the local market and says there’s still much to be optimistic about given the 12 per cent nominal return that has made it one of the best global performers.

Taylor says it comes back to key variables and what we have in place is pretty good for the next five years to come.

“Firstly, markets which perform tend to be new economies with strong population growth. Australia has been one such population growth country with 1.6 per cent over the last century — that’s a key driver.

“Looking forward, most projections are over 1 per cent population growth, which is still strong. The OECD figure is 0.5 per cent so Australia is double the average … and means we have an underlying fundamental in place.”

Taylor adds that natural resources is a driver.

“We have the largest and best quality formations and a stable environment. That remains a given.”

The value of good corporate governance

According to Taylor, countries in the top performance scale have strong corporate governance environments.

“People focus on GDP growth but that doesn’t govern stock market returns. Corporate governance is important in allowing shareholders to make an adequate return. Economic growth doesn’t naturally transfer if other things aren’t in place. So that’s an attractive proposition,” he says.

Taylor also believes that Australia has a number of high quality companies — both global and national leaders — focused on return on equity.

“One of the best correlations on rate of returns is the dividend yield and real growth in dividends (inflation adjusted). Australia’s real return 7.6 per cent and the nominal return is 12 per cent, so that makes it one of the best in the world.

“If you look at the market today, the metric is the PE ratio, which is 14 or 14.5 times and earnings growing at 13 to 15 per cent and dividend yield of 4.4 per cent, so again we’re in line with the historical average. But it’s not cheap.”

Australian exports

Taylor points out that exports comprise 20 per cent of our GDP and commodities are only one part.

“The other interesting thing is that commodities have declined over time … but the Australian economy has significantly broadened. When I talk to people offshore, the standard thing that comes back is that Australia is all about commodities.

“Commodities are important; but there are other things too ... only 17 per cent of the share market is resources, so it’s not the be all and end all. And when I talk to people offshore, I point out that 45 per cent of the market is financials.”

Furthermore, as Taylor says, resources had been languishing until the recent rise.

“We’re going through a good patch and it’s been good for one or two years. And some say it will come off the boil.

“If you look back through history, you get periods of real price appreciation of commodities.

“For example, in 1900 there were 30 years of appreciation and post WWII, price appreciation for the next 30 years … and now, the impact of China and India. You would expect that if they industrialise then you will have a sustained period, but the bigger issue is that when things go up, they don’t go up in a straight line.

Taylor says while it is difficult to take a three-month view “if you have three, five, 10 years, then there’s a strong argument for commodity price strengths and mining stocks performance”.

A market on the rebound

AMP’s Dr Shane Oliver reported that the recent December half reporting season contributed to a market rebound with 74 per cent of results meeting or exceeding expectations and profit growth coming in at 22 per cent.

Goldston-Morris points out that outside of resources and commodities, a number of companies, such as David Jones and JB Hi-Fi, are running well, largely through cutting costs and reducing their working capital.

“This half year, earnings growth is up slightly, but the major influence is the strength of the offshore stocks. While resources are good, those industrials which benefit from offshore include businesses, such as Rinker, Brambles, QBE, Aristocrat and Billabong,” he says.

Elsewhere, the consensus view is that US interest rates should be peaking in 2006 and regional rates will remain low.

Thanks to benign inflation figures in the December quarter, the consumer price index is running at 2 to 2.5 per cent for the year.

Exposure to property

Low interest rates mean local property as a class still bubbles along. But over the past two years, investors have sought more exposure in equities.

Brad Matthews, manager economics and research, Hillross, says that when new clients come they are often overweight in property, so planners may take a view that they “have a heightened exposure to interest rates and should bulk up on equities and cash”.

For example, if an investor with a balanced profile has 50 per cent of their assets already in property, Hillross may allocate the remaining money into 70 per cent equities (Australian and international), 20 per cent fixed interest and 10 per cent cash; as opposed to the standard distribution which is 60 per cent equities, 25 per cent fixed interest, 10 per cent property and 5 per cent cash.

“That’s one way of making the portfolio more robust,” Matthews says.

“The reasoning is that property is vulnerable to higher interest rates, so fixed interest should be pulled back and additional property exposure avoided.

“Our strategic benchmarks are different to our tactical benchmarks, which are changed on our perception of the short-term direction in markets. Over 2005, we were running at 5 per cent overweight to Aussie equities and now it’s 1 per cent underweight … we think it’s reached the upper levels of fair value.”

Portfolio construction

Matthews says that generally a portfolio suitable for this kind of switching would be over $250,000, but the money in a platform makes even small balances easier to move around.

However, recent growth in Aussie shares means that some investors have portfolios out of kilter, Matthews says.

Portfolios may have moved from 40 per cent Australian equity weighting to 45 per cent, purely due to market growth, so investors need to seriously consider moving back to their original benchmarks.

“At the end of the day, you don’t want to be overexposed to one market and that needs to be watched closely.”

Dinyar Irani, manager of private client investment, Genesys, develops positioning papers and model portfolios for adviser guidance.

“We’re not trying to tell people to chop and change, but where something is fundamentally overpriced or under, we try to get them to construct the portfolio to minimise risk.

“If you look at the domestic market, resources are going well, but there could easily be a hiccup along the way if the market suspects a slowdown in Asian growth. Retailers are looking flatter; also property is not expected to make major gains.”

Irani is not expecting a big correction, because he says “there’s less speculative froth this time around and many of the gains are driven by increased corporate earnings”.

“We’re just starting to perceive a toppy market and can’t see future earnings growth as strong,” he adds.

“Some sectors aren’t represented domestically, such as large pharmaceuticals and information technology. In Australia, it’s very much about financial and resources companies. Banks may not do so well, even though they’re seen as a defensive play. In the wrong scenario of a recession, banks are highly leveraged and will suffer for it.”

A long-term strategy

Irani is also suggesting alternatives in many different ways — whether a broader basket of commodities, low risk hedge funds or precious metals exposure via bullion holdings or equity investment in listed companies.

He adds that precious metals producers will be naturally more volatile. Holding bullion through exchange-traded funds or via the Perth Mint is another option for more conservative investors.

Goldston-Morris points out that the producers can be operationally erratic and suffer from skill shortages, such as for tradespeople and engineers as well as for spare parts. So it’s a difficult call.

MLC’s Susan Gosling acknowledges that the commodity super cycle has led to an even more determined chase by investors to cash in on the returns and “so to that extent, it can be unsustainable”.

“Typically, commodities haven’t been included in long-term funds because of the very long cycles. It makes it hard to build into a portfolio, which has a short-term focus,” she says.

“If only we could get away from short-termism,” adds Gosling, who sees this as a risky and value-destroying way to invest.

She emphasises that financial planners could really add value by getting clients to stay with their strategies and to focus on the long haul.

“MLC’s CIO Chris Condon talks about the BBQ risk — it’s less pronounced than the tech bubble, but still, everyone’s looking for the magic silver bullet.”