Treasure Chest: Brokers Do It With Conviction

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By Greg Peel

It's a time of great uncertainty in world financial markets, including from an upside perspective (if we look at Monday's ASX 200 performance). While it is the purview of investment strategists to make portfolio allocation recommendations between stocks, bonds and other assets, equity strategists and analysts start by assuming equity holdings and then allocating recommended portfolios based on expected under/outperformance to the equity market.

Goldman Sachs last week launched its Australia and New Zealand Conviction List (ANZCL) which represents the broker's strongest current ideas selected from each of the eleven sectors on either side of the Ditch, or a total of 234 stocks under coverage. The broker has selected 24 stocks for which it holds either a Buy or Sell rating with conviction.

The aim of the ANZCL is to “identify the stocks we believe offer the best alpha generation potential,” Goldman suggests, “by capitalising on short term catalysts or short term fundamental opportunities”. “Alpha” refers to that element of a stock's total return which is not related to the market return, implying under- or out-performance. By maintaining an equal weighting of the stocks in the list, the broker is not attempting to “call” the market itself but rather to identify individual stock ideas based on individual elements.

The Conviction Buy list is made up of ANZ Bank ((ANZ)), Asciano ((AIO)), Austbrokers Holdings ((AUB)), Australian Infrastructure Fund ((AIX)), Carsales.com ((CRZ)), Emeco Holdings ((EHL)), Fletcher Building ((FBU)), Freightways ((FRE.NZ)), Iluka Resources ((ILU)), Iress ((IRE)), Lend Lease ((LLC)), News Corp ((NWS)), Oil Search ((OSH)), OneSteel ((OST)), Orica ((ORI)), Primary Health Care ((PRY)), Sky City Entertainment ((SKC.NZ)), St Barbara ((SBM)), Suncorp ((SUN)), Super Retail ((SUL)), Wesfarmers ((WES)), Westfield Retail Trust ((WRT)), and WorleyParsons ((WOR)).

There is only one stock in Goldman's Conviction Sell list, being Independence Group ((IGO)).

BA Merrill Lynch maintains an conviction list based on the wider Asia-Pacific market, which includes Australia, called the “Asia Pacific Focus 1 List”. The list contains 20 listed stocks from across the region. Last week Merrills made some portfolio changes.

Incumbent and remaining in the list are Mirvac Group ((MGR)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)). Exposures to higher than expected natural peril losses, interest rate volatility and doubts over bank provisioning see Suncorp ((SUN)) exit the list, and downgraded expectations for Wesfarmers' ((WES)) non-retail sector earnings, particularly for coal, mean that company also departs.

Coming into the list are ANZ Bank, which is Merrills' top bank sector pick based on earnings potential of ANZ's Asian expansion, a strong funding position relative to peers and solid valuation upside potential. The other addition is Treasury Wine Estates ((TWE)), for which Merrills sees positives in an apparent turning of the wine cycle, TWE's ability to fully leverage the cycle, and TWE's strategy of growing premium wine production.

Last week the Credit Suisse small cap analysts reviewed their small cap retail recommendations, resulting in some ratings changes. 

Super Retail Group ((SUL)) already enjoys a dominant position, and this should be extended through the company's sensible operational investments and through expansion into auto trade, CS suggests. The broker has lifted SUL to Outperform from Neutral. Oroton Group ((ORL)) has received a similar upgrade, with the analysts citing Oroton's superior earnings growth and efficient embrace of the changing retail landscape.

On the other side of the consumer coin, Specialty Fashion Group ((SFH)) has been downgraded to Underperform from Neutral. The analysts note SFH is in a net cash position, but the subdued retail environment will put a strain on rent payments for some 900 leased stores. Premier Investments ((PMV)) sits in the mid-range of Australian apparel retailing, Credit Suisse notes, which is unfortunately the range suffering the most from subdued activity. The analysts expect a downgrade to FY12 guidance and maintain Underperform.

Credit Suisse maintains a Small Cap “Focus List” in the same vein as the lists above, all of which are Outperform convictions. The list has not changed as a result of the broker's retail sector ratings changes, and comprises of FlexiGroup ((FXL)), IOOF ((IFL)), Cabcharge ((CAB)), McMillan Shakespeare ((MMS)), Programmed Maintenance ((PRG)), SAI Global ((SAI)), SMS Management & Technology ((SMX)), Flight Centre ((FLT)), Webjet ((WEB)), Wotif ((WTF)), Carsales.com, STW Communications ((SGN)), Alliance Aviation ((AQZ)), Bradken ((BKN)), Gindalbie Metals ((GBG)), Kula Gold ((KGD)), Industrea ((IDL)), Mermaid Marine ((MRM)), NRW Holdings ((NWH)), Qube Logistics ((QUB)), Royal Wolf ((RWH)), and TPG Telecom ((TPG)).

From a wider market perspective, Citi's equity strategists have been looking at the current state of Australian stock market valuations in light of the recent round of renewed euro-fear (with a bit of China and US concern thrown in). They note that the recent outperformance of local defensive sectors is similar to that of 2008-09. Defensive sector PE premiums are now at levels seen last in late 2011, and previously in early 2009, and Citi notes that on each occasion premiums have subsequently unwound somewhat, allowing a pick-up in cyclical stock valuations.

In other words, Citi warns defensive stock valuations are looking overstretched, particularly given only modest earnings growth forecasts in most cases.

On the other hand, Citi notes the global economy has not actually slowed that much overall, yet commodity prices have taken quite a tumble. On that basis, and on the premise of switching away from overvalued defensives and into undervalued cyclicals, Citi favours the resource sector.

A rise in resource names would have a positive impact on the index, which in turn would provide a boost to the banks, Citi suggests. However structural change elsewhere in the economy is restricting any particularly positive view on other domestic cyclicals.
 

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