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Outside the square thinking required

To find the best Australian equities investment opportunities in 2017, individuals will need to consider stocks outside the top 20 and be wary of optimistic earnings forecasts, writes Julian Beaumont.

In the past 12 months, the market has gone from a seemingly permanent low-growth, low-yield world to one where markets now expect strong growth and rates to rise.

This has played out in the market reappraising those companies that were offering what was previously rare – growth and yield.

Indeed, a number of good growth companies have been sold off lately, without any deterioration in company fundamentals. While this can create good buying opportunities for investors, it also raises concerns about the level of ‘heat’ in the market.

This has set the scene for an interesting start for equity markets in 2017. In our view, some caution should be exercised in relation to the market’s lofty growth expectations.

We think the resources sector can deliver against, or even beat, earnings expectations. Here, share prices assume quite conservative commodity prices that, in many cases, are somewhat below current levels.

However, earnings growth is likely to fall short elsewhere. Consumer and industrial stocks face quite significant earnings risk and investors should remain cautious. For us, this means we are particularly focused on those companies that will be able to deliver or hopefully beat the market’s expectations of what they will earn.

Mixed economic outlook

As a backdrop, the performance of the various global economies is mixed. The world’s largest economies – the United States and China – are growing nicely. However, this is in contrast to most of the rest of the world and indeed to the Australian economy.

China is currently benefiting from fiscal and credit stimulus in the lead-up to elections later this year. In Australia, we are seeing this in strong demand and pricing for our iron ore, coking coal and other commodities, as well as in inbound tourism, housing and other investment.

The US economy is also lifting steadily, particularly at the consumer level, which accounts for about 70 per cent of the economy. The US economy may now also benefit from pro-growth efforts by a Trump administration.

On the other hand, we regard the Australian economy as generally sluggish currently. Corporate investment and hiring is weak overall, the consumer is highly indebted, wages are struggling to grow, and state and federal governments mostly seem fiscally constrained.

There are, however, some pockets of growth. These include the tourism, healthcare and construction industries, and, geographically, the New South Wales economy (specifically Sydney). The domestic economy has – so far – succeeded in its transition away from the resources focus of the past decade, although further signs of softness are coming to light, including for example, in NSW. There are a number of hopeful scenarios, but the most likely is for continued slow growth in Australia.

Attractive valuations?

Valuation metrics for Australian equities such as multiples of forward earnings appear quite reasonable overall, particularly in the context of still low interest rates and lofty asset valuations elsewhere. A note of caution is, however, warranted. The consensus earnings on which these valuation metrics are based assume quite bullish earnings growth around 14 per cent. Admittedly, a large part of this growth owes itself to the strong growth in earnings from the mining and energy sectors, which are benefiting from the higher commodity prices. However, beyond these sectors, the strong growth is at odds with what appears a sluggish domestic economy.We believe this gives rise to considerable earnings risk – that is, the risk companies will disappoint on earning compared to expectations. Stock prices, which implicitly ‘bake in’ these expectations, tend to falter if companies provide weaker-than-expected guidance or disappointing financial results.

We believe the generally soft real-world trading conditions across most sectors indicate some disappointment ahead, and the February reporting season will be one to watch closely. Indeed, the stock market appears quite sensitive at present. Over the past few months, the stock price reactions to negative news have been quite brutal. In contrast, positive news has gained a more muted response.

The recent profit warnings offer some useful lessons for investors:

  • be wary of promotional management,
  • be wary of large insider selling,
  • be wary of companies that have been floated by private equity, and
  • be wary of new acquisitions.

These may not be reasons to avoid a stock, but they do suggest additional due diligence is required.

Figure 1: ‘Snail trail’ of ASX 300 Index EPS estimates ($)

Source: BAML, BAEP, as at 31 December 2016

Investor themes for 2017

The key to investment success in 2017 will be to buy into companies that can deliver above what is expected of them and where this has been priced into their share prices. Another key theme will be looking beyond the usual suspects to find the best investment opportunities. In recent months, we have seen the traditionally popular bank, resource and other mega-cap stocks rise strongly, providing good returns to their investors. In many instances, this has come without much improvement in the company’s fundamentals. This has left less potential return in them for the future, meaning investors will increasingly need to look outside the top 20 stocks on the ASX to find opportunity.

The search for earnings delivery

Stock prices are set by the market to reflect its expectations of the company’s future prospects. And as anyone familiar with the workings of the widely-used valuation tool, the price-to-earnings (PE) ratio, will understand, it is the company’s future earnings prospects that really matter. Some might be bemused by a fall in a company’s share price on reporting very strong earnings growth or a sharp rise on a weak one. Ultimately, share prices move based on performance versus expectations, and how those expectations evolve over time.

This is particularly important in a world where earnings expectations for the market currently appear quite lofty. It turns out the market’s optimistic view of the world is quite common.

For every year since 2007, it has overestimated what the aggregate of ASX-listed stocks could achieve. If earnings again disappoint, some of the ‘heat’ in the market may well come out.

For investors, the advice is to be conscious of the expectations priced into a particular stock and consider how the company might fare against those expectations. Understanding both of these things is inherently imprecise. And ultimately it involves hard work in undertaking extensive due diligence on the companies involved.

At Bennelong Australian Exchange Partners, this means talking with the companies themselves, their customers, suppliers, competitors and regulators. In this respect, investing is a relentless task of digging deep and then digging even deeper. In addition, some of the outward signs may be useful in understanding what is happening inside the company.

The lessons discussed above are relevant here, leading one to be cautious, for example, of over-promotional management that raise investor expectations, or of large insider selling that suggests the internal view of the business’s prospects might not be as optimistic as the views of investors looking in.

Going outside the comfort zone

As mentioned, another key theme for 2017 will be going outside the traditional comfort zone of the big banks, resource and other mega-cap companies in order to achieve outsized investment returns, but also to manage risk.

The Australian market is concentrated like no other. The top 20 mega-cap stocks on the ASX account for 60 per cent of the total value of the S&P/ASX 300 Index.

In our view, it is almost impossible for any investor – professional or not – to deliver outperformance from the top 20 stocks, which are so heavily researched, monitored and analysed that there is relatively little opportunity for anyone to gain and leverage insight. A company such as BHP is covered by almost 40 brokerage houses across London and Australia, not to mention the considerable attention it gets from professional fund managers, investors and the media. In this context, the opportunity to outthink the market is limited.

But it’s a different story outside the top 20 stocks. Companies are much less researched and, in some instances, not covered by any analysts at all. These stocks are also relatively unknown to the broader public. This means the market is much less efficient and provides opportunities for investors to access outperformance.

This doesn’t mean ignoring the top 20 stocks. They still deliver valuable returns for investors, not least in their dividend yields. But many investors have concentrated their portfolio solely on these big companies, and therefore don’t have access to the returns and growth prospects available at the smaller end of the market.

It’s fair to say this is particularly true of SMSFs. A recent study by SuperConcepts showed the top five holdings of SMSFs were, in order: Commonwealth Bank of Australia, Westpac, Telstra, ANZ and National Australia Bank. BHP and Wesfarmers also made it into the top 10 list, which represented almost 14.4 per cent of total assets. In 2017, savvy investors will need to look beyond the comfort zone if they wish to find decent opportunities.

Overall, we believe the Australian stock market offers reasonably attractive returns over the medium term, but, as outlined above, it will also be necessary to remain selective. This includes understanding what the stock market valuation implies in terms of expectations and whether they are reasonable compared to what the company can deliver.

Julian Beaumont is investment director at Bennelong Australian Equity Partners.

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