Not As Bad As You Think

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By Rudi Filapek-Vandyck, Editor FNArena

It has been one of the ever recurring questions among share market investors in Australia: why is it that the Australian market cannot keep up with the US?

Instead of trying to resolve the enigma (?) through the usual explanations such as sub-par growth for the domestic economy, a much stronger currency, lack of profit growth and no money printing support from the RBA, I decided to delve into another approach instead. Miners and energy companies take up a much larger part of the major share market indices in Australia than in the US, so what happens if we remove this anomaly? Make sure you're sitting down, because you are in for a few surprises.

First, let's see why investors in the Australian share market are so unhappy today. The S&P500 index, widely considered the most representative benchmark for US equities, has today more than doubled from its low in 2009 (up 102%) and as a consequence of this strong performance, the all-time high of October 2007 doesn't appear to be that far off anymore (circa 12%).

In Australia, however, the performance has been far more muted. The ASX200 has barely recovered 36.5% since bottoming in March 2009 and that means the peak from October 2007 is still nowhere near; there's yet a gap of 36% left to recover.

To add insult to injury, 2012 has thus far seen a continuation of the Australian underperformance, with US equities since the start of the year rallying 18.25% (Nasdaq), 11.17% (S&P500), 10.43% (Russell 2000) or 6.90% (DJIA). In Australia, the All Ordinaries is up 7.6%, the ASX200 index is up 6.9% and the Small Ordinaries is up 14% for the year.

One important factor has to be pointed out: shares in technology juggernaut Apple are up more than 50% for the year and Apple is a major index weight for both Nasdaq and S&P500. Apple is absent in the Dow Jones Industrial Average which just happens to be the index that is lagging all others, including indices in Australia. So… is Apple the answer we are looking for?

No. But Apple does make a big difference with experts in the US calculating the stock has been responsible for more than 20% of all gains booked by the S&P500 thus far this year, and even more for the Nasdaq. This is the direct impact. There is, of course, the unmeasurable impact on sentiment and share prices for other technology stocks.

Let's stick with the 20% gains for the S&P500 that can be directly attributed to Apple shares. This means that without Apple -all else being equal- the S&P500 would only be up less than 9% this year. Still higher than the 7.6%-6.9% achieved in Australia, but a lot closer. Were we to swap Australia's largest index weight, BHP Billiton ((BHP)), with Apple shares we would instantly reverse the situation.

Now that we've mentioned BHP…

The Big Australian is so far not only in the red for the year, but significantly lower than at the start of 2011 as well as since the start of 2010. Instead of blaming BHP, or Rio Tinto ((RIO)), or Newcrest ((NCM)), or Woodside Petroleum ((WPL)), I decided to remove all miners and energy companies from the ASX200 index. US indices contain many more industrial companies so maybe the comparison ex-miners and energy producers is more apt? Let's find out…

Removing miners and energy companies from the ASX200 has left me with 137 companies, of which some are relatively "new" such as Westfield Retail ((WRT)), Echo Entertainment ((EGP)) and Treasury Wine Estates ((TWE)). I have left these newer members out of this exercise. As well, I simply weighted all 130 remaining stocks equally, unlike how Standard and Poor's constitutes its indices. While this is very unscientific of me, this exercise is not about copying S&P, it's about offering a different perspective.

So… if the ASX200 had contained no miners and no energy stocks and only 130 industrials, banks, insurers, property trusts, retailers, media companies, builders and developers, the index would be 16% higher than where it is today (measured from 31 December 2009). Note the gap in investment returns with the US would be far smaller because since the beginning of 2010 these 130 stocks would have paid out circa 12% in dividends on top. The difference in total investment return over the past 2.5 years (to be precise: 27.5 months) is thus circa 28%.

It gets better still…

Taking a look at our conceptual ASX130, the gain since the start of 2012 would have been no less than 13.3%, dividends not included. This means that even with Apple included in US indices, only the Nasdaq has done better this year. Remember: Australian companies pay a far superior dividend than peers in the US, in particular in comparison with US technology stocks.

As a matter of fact, only 17 constituents of our ASX130 index are today trading below their share price from the start of the year. This does not mean these 17 have all delivered a negative return for shareholders as companies such as Suncorp ((SUN)), GWA Group ((GWA)) and Hastings Diversified Utilities Fund ((HDF)) are good dividend payers. As such, only nine out of the 130 are genuinely in the red this year. CSR ((CSR)), down nearly 16% year-to-date, is by far the worst performer this year.

On the other end of the spectrum, we find companies such as Imdex (up 74%), Billabong (up 61%) and NRW Holdings (up 60%). Note that while our ASX130 contains a number of services providers to mining and energy sectors, it would be far too easy (and factual incorrect) to make these stocks responsible for all or most of this year's gains. Note that Virgin Australia ((VAH)) is up 53% this year, Aristocrat Leisure ((ALL)) is up 44% and Super Retail Group is up 42% year-to-date.

Many of the typical yield plays have put in an absolute mind boggling performance over the past 3.5 months. Note that Telecom New Zealand ((TEL)) is up 25% for the year, Macquarie Atlas Roads ((MQA)) is up 23% and Ardent Leisure is up 22.5%. All these stocks pay out an above average dividend on top!

Time to draw a few conclusions:

– The Australian share market has suffered a great deal from the economic slow down in China because its indices contain such a high representation of mining and energy stocks. Note that materials stocks, the label for miners in the US, are the worst performers in the US year-to-date. The materials sector has also suffered the largest falls in earnings forecasts year-to-date (without the extra currency impact peers in Australia have to endure);

– This also suggests that any positive impact from RBA rate cuts on the share market will easily be outweighed by monetary easing or further stimulus from China later in the year;

– The relative performance of the Australian share market outside the direct China effect has been much better than generally assumed. Note that the Small Ordinaries in Australia has outperformed the Russell 2000 year-to-date, without taking into account the superior dividend yield;

– All of the above probably also explains why stockbrokers continue issuing more downgrades than upgrades, despite Australia's apparent subdued performance. In the week past FNArena registered 14 downgrades and only three upgrades from the eight stockbrokers we monitor daily. This has been the pattern for many weeks now. Non-mining and energy stocks today are not necessarily cheap given many of them have put in quite an extraordinary performance, albeit largely under the radar given everybody's fixation with what the indices are doing;

– None of the above suggests there's no value to be found outside miners and energy stocks;

– It would be too simplistic to connect the general de-rating for miners and energy producers solely to the slow down in China. Global investors are obviously no longer prepared to blindly accept that a continuation of the Super Cycle will automatically lead to continuously growing profits and value for shareholders. The present financial year will likely see both BHP Billiton and Rio Tinto report negative growth in earnings per share. The challenge for investors will be to find those companies that can grow their volumes and profits well beyond the stagnation in commodity prices;

– The above may also serve as a warning for longer term investors to not put too many retirement eggs into the resources basket. In fact, for investors (as opposed to traders) resources stocks hold a rather dubious track record in the post-2009 era, as again proven by the calculations and comparisons above;

– In order to make the comparison between our ASX130 and US equities more genuine I should remove all materials and energy stocks which have equally held back the overall performance over there. But maybe the easiest comparison is with Nasdaq which contains no materials and energy stocks whatsoever. In that case, we truly can say that the real difference between equities in the US and in Australia comes down to two words: "(industrial) commodities" (see all of the above) and "Apple".

With regards to Apple, have a look at the truly parabolic rally Apple shares have enjoyed thus far this year. Doesn't that make you think that if US equities are to have a "correction" in the foreseeable future, the "how" and "when" will be derived from this chart? (At least BHP is trading on a PE of 10).

(This story was originally written on Tuesday, 10th April 2012. It was sent in the form of an email to paying subscribers on that day).

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