Brokers Update Equity Strategies

This story features WOOLWORTHS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WOW

The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

– Yield chase continues
– Other opportunities now emerging
– Sustainable growth important
– Global economy stable

By Greg Peel

CIMB believes market concern this month over slowing Chinese growth and a stronger US dollar have been overdone, which in turn suggest commodity price weakness is overdone. All things being equal, a stronger US dollar implies lower dollar-denominated commodity prices. This scenario should play out if dollar strength is only due to a wind-back of Fed easing policy, but in theory the Fed will only begin winding back policy if the US economy is strong. If the US economy is strong, commodity prices should be supported.

If the Chinese economy is weak, then it makes sense for dollar-denominated commodity prices to fall. If the US economy is strong, we have the competing forces of higher expected demand for commodities and the implicit stronger greenback. The exception is gold, which is not an end-use commodity but a currency proxy. If the US dollar rises, the dollar-denominated price of gold should fall assuming low inflation expectations.

CIMB does not see the Chinese economy as weak as others in the market fear, and underlines the point that a strong US dollar does not by default imply weaker commodity prices. The Chinese recovery from 2012 is indeed modest, the analysts acknowledge, but is a recovery nevertheless. Growth in commodity consumption will not be as strong in China as in previous years, but growth should still be enough to keep commodities in tight supply.

The supply side of the commodities price equation is equally as important as the demand side, and here there have also been fears of growing global supply meeting falling global demand. But such a fear ignores the fact that lower prices make high-cost production uneconomic, and CIMB suggests that at current spot prices as much as half of global commodity production is uneconomic. High-cost supply will shut down to offset growth in lower cost supply.

CIMB is bullish on prices for oil, copper, tin and the platinum group metals, and neutral on natural gas, coal (thermal and metallurgical), uranium, lead, zinc, nickel, iron ore and the precious metals. CIMB is bearish on aluminium.

Commodity prices remain fundamental to the strength of the Australian economy, and no less so now that we are transitioning into the “supply” phase from the “growth” phase in mining. Weak commodity prices, and resultant lower tax revenues, have shot the government’s foolishly optimistic budget projections to pieces. Yet this government, and the incoming government, are both committed to a return to surplus come hell or high water. Thus while the RBA eases, the government tightens.

It is this “fiscal drag” which Macquarie sees as the critical take-away from last week’s Federal Budget, and a new government will be little different. Treasury has downgraded its GDP growth forecast to 5.0% for FY13-14 from 5.25% and Macquarie (and just about everyone else with a pulse) considers this forecasts still too optimistic. With the government’s spending cuts (or deferred spending) to be funded by increases to (or deferred decreases to) business tax increases, there will be no much needed boost to business confidence. The analysts see such policy as only serving to drive further corporate cost-cutting and productivity increases to offset weaker consumer and business demand.

Domestic fiscal policy, as well as global economic conditions, have forced the RBA to cut its cash rate further and it is likely the central bank will need to cut yet again. The resultant low interest rate environment is driving the great “yield chase” in the Australian (and global) stock market. Investors who turned to yield early have benefited from a re-rating of price/earnings (PE) ratios among high yielders above and beyond the market’s net PE re-rating. But with share prices now in many cases fully capturing the value of yield, and with payout ratios having already been lifted, Macquarie believes better risk/reward opportunities are now emerging elsewhere in the market.

However, there remain listed companies which should be able to sustainably lift dividends per share and these are still likely to see a positive share price reaction, Macquarie suggests. They include companies which would not necessarily be considered as “yield stocks”, such as CSL ((CSL)), Woolworths ((WOW)), News Corp ((NWS)), Flight Centre ((FLT)), Platinum Asset Management ((PTM)), Seek ((SEK)), Santos ((STO)), TPG Telecom ((TPM)), Asciano ((AIO)) and Aurizon ((AZJ)).

Macquarie also disagrees with market consensus recommendations on DuluxGroup ((DLX)), not with regard to yield but from an earnings growth potential. Macquarie rates the stock as Outperform. The same is true for Arrium ((ARI)).

Macquarie also disagrees with consensus recommendations on various other stocks, but in these cases the broker is holding Underperform ratings against otherwise positive consensus. Those stocks are AMP ((AMP)), Cochlear ((COH)) and Westfield ((WDC)).

RBS Morgans (CIMB) has taken a step further than Macquarie and, on the argument of the yield rally now having run its course, has begun to identify opportunities in the “growth stock” category. Whereas yield stocks tend to be defensive, growth stocks tend to be cyclical. The analysts have selected ten stocks which they believe offer attractive growth upside on a five-year view, based on four “future growth drivers”.

The first such growth driver is the ageing population, which underpins value in healthcare and retirement planning. Here RBS likes Sonic Healthcare ((SHL)) and AMP ((AMP)). The second is internet data growth and the commoditisation of internet revenue, offering up Next DC ((NXT)) and Carsales.com ((CRZ)).

Third is the LNG and shale revolution of the energy sector, and here RBS likes Oil Search ((OSH)) and WorleyParsons ((WOR)). Fourth is the Asian consumer growth story along with global consumer trends in food and travel. In this category the analysts prefer Domino’s Pizza ((DMP)), ALS ((ALQ)), Amcor ((AMC)) and Corporate Travel ((CTD)).

Citi notes that the yield-based rally has been focused mostly on large cap stocks and has left the small cap space behind, to the point at which relative performance is still at ten-year lows. The result is that many small industrials are looking attractive on a relative value basis, but Citi’s warns that this could be a “value trap” in many cases. The Small Industrials sector is forecast to provide a net negative return ahead.

Citi warns investors only to consider small industrials with solid balance sheets, good cash coverage and the potential for earnings growth. On this basis, Citi’s preferred candidate is M2 Telecoms ((MTU)), while Forge Group ((FGE)), G8 Education ((GEM)), Miclyn ((MIO)), McMillan Shakespeare ((MMS)), Southern Cross Media ((SXL)) and TPG Telecom all rate a mention.

The same argument does not necessarily hold for the Small Resources, given sentiment has been so weak in this space. Sentiment is not improving, Citi notes, but relative valuations suggest there is only so far some stock prices can fall. On this basis, the analysts see support for AWE ((AWE)), Mt Gibson Iron ((MGX)) and Sandfire Resources ((SFR)).

Aside from looking for Australian stocks with “future” growth potential, RBS Morgans has been advising Australian investors, since late last year, to diversify into overseas markets for growth. While many foreign equity markets have also had a good run in the interim, many are still cheaper on a PE basis than the local market. The Aussie dollar, although weaker than it was, still offers up a good entry point.

The good news is that investors do not have to actually trade overseas in order to gain overseas exposure. The ASX now boasts a number of locally-listed and Aussie-denominated exchange traded funds (ETF) which provides the local investor with exposure to portfolios of foreign stocks, and overcome the constraints the Australian market offers in terms of achieving exposure to all industry sectors and themes. The bad news is that foreign investment does not offer franking benefits, hence return comparisons must be made on a full taxation basis.

RBS Morgans highlights four ETFs recommended by research partner Morningstar. They are the iShares S&P 500 (ASX code IVV), which tracks the US broad market S&P 500 index, the Vanguard US Total Market Shares Index (VTS), which tracks the MSCI US Broad Market Index rather than the S&P 500, the Vanguard All-World ex-US Shares (VEU) which, as the name suggests, invests everywhere but in the US for a total of 2,200 separate company exposures, and the iShares S&P Global 100 Index (IOO) which invests in 100 global large cap stocks (although not necessarily the top 100 by market cap).

The UBS global equity strategists were feeling worried in February as the sharp rally progressed given the prevailing issues of Italy, Cyprus and US sequestration. In May, UBS is not so worried, suggesting global economic momentum has stabilised, fears of a more sinister soft patch have eased, and technical indicators are pointing to a greater rebound in risk appetite, which should imply stronger cyclical performance.

Valuations have continued to rise, meaning the total return outlook is less compelling now than it was in February, but risk premiums should continue to ease as the global economy continues to normalise, suggests UBS, central bankers are pushing investors into riskier assets and the relative valuation case for equities (against other assets) remains hard to ignore.

To reflect its change of heart, the strategists have upgraded their global Financials rating to Overweight, while reducing Energy to Neutral and Telcos to Underweight.

A compliant Fed has looked on while Wall Street has crashed through prior peaks, notes Citi’s US equity strategists, aided by improved US corporate credit, solid earnings and improved data such as jobless claims. The rally is now exhibiting a level of capitulation, in that previously wary traders have joined in despite already having assumed the market was overbought. Citi suggests this “overshoot” could continue for a bit longer before the usual summer back-off (otherwise known as “sell in May”) occurs.

The market may seem overbought, but Citi cites a few typical indicators which suggest this may not yet quite be the case. Investor surveys in the US have become more bullish than bearish but not as bullish as has been marked in previous rallies. New IPO numbers have increased but not by much more than last year. The broker’s own panic-euphoria index is Neutral, but the analysts are suggesting more interest in the market from potential investors. And valuations overall do not yet look particularly threatening on a variety of measures (PE or otherwise).
 

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