No Fireworks On The Horizon

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By Rudi Filapek-Vandyck, Editor FNArena

It was but a matter of time, I reckon. After four years of relentless disappointment and a dramatic change in market perception respectively for resources and for bank stocks, investment strategists at Morgan Stanley have finally dared to make the suggestion few are brave enough to propose:

How about investors in Australia forget about resources and banks and concentrate on what is most likely to generate outperformance?

Morgan Stanley suggests building a portfolio around a new barbell of defensive and cycle-agnostic growth. Characteristics that are more likely to be found outside of the 45% of the share market index made up by the two most prominent constituents.

Australia's Top Companies Are Struggling

Before we delve into the categories Morgan Stanley strategists like, let's first explore the issues that have dogged the Australian share market for at least the past two years, for they are the fertile ground from which the new Morgan Stanley portfolio strategy was born.

Total investment return for the ASX200, including dividends, was less than one percent in 2014 and it looks like 2015 won't be materially different.

Most sectors in Australia are dominated by one or two dominant market leaders. Such cosy duopolies serve shareholders well, as shown by past performances from the likes of Woolworths, Wesfarmers and Telstra. But things are changing. Either regulators are taking a keen interest, or foreign competition is arriving on Australian shores, or rapidly emerging new technologies and business models are disrupting and changing market dynamics.

All these changes are taking place against a background of persistent sub-trend growth worldwide, ongoing growth deceleration in China and a re-balancing domestically as the gi-normous mining and energy capex phase has peaked and has started to wind down. This process of re-balancing the Australian economy is slow, uneven and unfinished.

On top come plenty of things to worry about, especially since a number of experts is now anticipating a reversal in the Australian housing and construction cycle.

One look at analysts forecasts for Australia's largest listed companies instantly reveals where the main problem lies: little to no prospects for growth. Recent company updates, including from Telstra ((TLS)), three of the major Four banks, and various retailers, have simply vindicated these low-ball forecasts.

In many cases, company market updates have led to even lower forecasts. Others, such as Harvey Norman ((HVN)), JB Hi-Fi ((JBH)), Mirvac ((MGR)) and Stockland ((STG)) might still be enjoying firm wind in the sails but they all carry serious question marks. How much longer is it going to last?

A study by PricewaterhouseCoopers predicts the major banks' average net interest margin (NIM), the bread-and-butter for dividends and shareholders, is on its way to fall below the 2.05% record low reached in 2008.

Adrian Turner, the newly appointed technology entrepreneur hired by the Turnbull government to help building new digital industries in Australia, believes domestic oligopolies in industries such as finance, insurance and supermarkets have made the companies involved "inward-focused", thereby stifling innovation and adoption of new technologies^(*).

Morgan Stanley strategists add one more, equally important factor: market concerns about Emerging Markets, debt and deceleration in China in particular, have not been resolved.

Defensive and Cycle-Agnostic Growth

The share market's exuberance last week in the wake of the Chinese authorities abandoning the country's One-Child policy is exemplary for the current share market, in my view. All of investors' enthusiasm was directed towards stocks like a2 Milk ((A2M)), Bellamy's ((BAL)), Blackmores ((BKL)) and Bega Cheese ((BGA)) in further confirmation the most interesting, believable and marketable growth stories are not amongst the Blue Chip All-Time Favourites, but instead at the smaller end of the industrials and dairy sectors.

While many a large cap stock in Australia has struggled to remain in positive territory in 2005, stocks like IPH Ltd ((IPH)), APN Outdoor ((APO)) and Freelancer.com ((FLN)) are up by 100% or more.

But not all smaller cap stocks fit the bill and, equally important, many of the defensive stocks are already well-priced in a market that has seen "risk" being punished time and time again. Morgan Stanley strategists thus recommend a barbell approach built around "defensives that can still surprise", such as Insurance Australia Group ((IAG)), Aveo Group ((AOG)) and Qube Holdings ((QUB)), and stocks for which growth comes from self-help or is endogenous in nature. The strategists are thinking QBE Insurance ((QBE)) and Mantra Group ((MTR)).

Morgan Stanley strategists predict the Australian share market might find it hard to post sustainable gains in 2016. Seeking out cycle-agnostic growth seems but a logical way to create "alpha" (outperformance against the broader market).

Equally important, they do not believe a lift-off scenario for US rates will trigger an aggressive unwind in defensive stocks.

Stockpicking Is Required

Market strategists at UBS are essentially singing to the same tune as their colleagues at Morgan Stanley in that genuine growth is pretty hard to find in the Australian share market these days, but they have adopted a different approach. UBS believes in stockpicking and in that bank shares should perform okay now that heavily dilutive capital raisings are behind the sector and mortgage re-pricing guarantees some growth ahead.

UBS still does not like resources and thinks the slowing demand worldwide is a theme that is going to stay with us for longer.

UBS strategists point out, outside banks and resources, predicted growth in earnings per share (EPS) is some 8% for the year ahead. This is quite meaty in itself. To locate the available opportunities, UBS strategists advise investors should focus on beneficiaries of a weaker Aussie dollar, including USD-earners, and on stocks whose growth stems from cost control and margin expansion.

Domestic cyclicals look oversold based on the UBS view that domestic housing will slow but not collapse, in addition to ongoing support from low interest rates. UBS thinks the RBA will deliver a rate cut on Melbourne Cup day.

UBS recently added GUD Holdings ((GUD)), Primary Health Care ((PRY)) and Stockland to its Model Portfolio. The strategists note the local share market doesn't appear particularly cheap, but blames this on resources stocks which overwhelmingly trade on high Price Earnings (PE) multiples.

Conviction Stocks

Over at stockbroker Morgans, general sentiment has been for a while that "caution" remains an investor's best friend in the Australian share market. Strategists note global equities have stopped falling, but only because central banks effectively prolonged the era of easy monetary policies as the US Fed delayed its first hike while the ECB promised more Quantitative Easing (QE) and China delivered rate cuts.

The following quote sums it up best:

"We think fickle market activity relates to the ebb and flow of investor risk tolerance ahead of potential global interest rate normalization over coming years, which presents a seismic shift for markets. The frustration is that we can’t predict with precision just when rate normalisation will begin take hold and we maintain a cautious market stance."

Morgans added AP Eagers ((APE)) and Vitaco ((VIT)) to its Ex-100 list of Conviction Buys, while removing Burson Group ((BAP)). Over at Credit Suisse, both BigAir ((BGL)) and Scentre Group ((SCG)) have been removed from the Australian Top Picks List (no new additions).

Goldman Sachs removed Tassal Group ((TGR)) from its Australia Small & Mid Cap Focus List in October.

ASX200 Range-Bound

Macquarie strategists remain equally sceptical about the local share market's potential in the remaining weeks of calendar 2015. In their view, valuations are not particularly cheap, growth is largely absent (emphasised by the fact consensus forecasts are still seen as too high) and the US Federal Reserve is indicating it remains on course to start lifting interest rates.

The over-ruling view at Macquarie is that the major index in Australia, the ASX200, is likely to remain capped inside the 4950-5350 range, "with the potential to retest lows".

Macquarie strategists too believe investment portfolios should remain defensive "with the intention of minimizing underperformance on the upside, rather than positioning for the upside and underperforming on the downside".

Macquarie's model portfolio is neutral Energy and Materials, while using Banks as a more tactical lever in that banks can either provide a lower risk way to leverage upside or to protect the downside. Macquarie remains overweight "growth" through stocks like CSL ((CSL)), Breville Group ((BRG)) and Cover-More ((CVO)) and overweight global industrials through holdings in Amcor ((AMC)), Lend Lease ((LLC)) and Incitec Pivot ((IPL)) but underweight domestic industrials represented by Mantra Group, DuluxGroup ((DLX)), Seek and Tatts ((TTS)).

Note to FNArena subscribers: on request from subscribers, FNArena will compile an excel sheet with the latest Top Picks lists and Model Portfolios as last published by stockbrokers. Send an email to info@fnarena.com to request your own copy.

(*) Adrian Turner gave an interview to the Australian Financial Review while on a trade mission in Israel

Rudi On Tour

– I have accepted to present to members of Australian Shareholders' Association (ASA) in Canberra, on Tuesday, 8th December 2015

Rudi On TV

– on Thursday, Sky Business, Lunch Money, noon-1pm
– on Thursday, Sky Business, Switzer TV, between 7-8pm

(This story was written on Monday, 2 November 2015. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via Editor Direct on the website).

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Odd as it may seem, but today's share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

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