Treasure Chest: Beware The Defensive Rollover

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By Greg Peel

For a year we've seen a strong rally in Australian stocks offering dependable earnings and yield. Sectors such as food retailing, healthcare, telecoms and even banks – each of which offer varying levels of traditional “defensiveness” – have particularly outperformed. The question being asked more and more often now is just how much more upside do these stocks have? Or worse, is there downside risk?

The Citi strategists ask investors to consider two factors. Firstly, this preference is a global phenomenon but Australian stocks in this category are trading at a premium multiple to global peers (yield adjusted) and secondly, foreign investors in Australian stocks do not qualify for franking credit tax offsets.

This means that Australian “defensives” are equivalently more expensive than US or other global counterparts and offer less after tax yield for foreigners than domestic investors. 

From the outside, foreigners have seen oligopolistic industry structures – think one big telco, two major supermarkets and four big banks – offering underpinned earnings and from inside, instos have seen all those lovely franking credits, Citi observes. Citi acknowledges that the local defensives are indeed producing dependable earnings, but only modest earnings growth, as was highlighted in the recent reporting season. 

Were uncertainty abroad begin to lessen, those Aussie stock premiums could very quickly come under pressure as foreigners rotate out of Australia and into local defensives, Citi warns.

Credit Suisse's quant boffins have emerged blinking into the sunlight to report that they don't feel investors should be looking for “value” plays in Australia. These are stocks which look historically cheap, thus apparently offering a bargain.

The quants believe Australian households remain susceptible to deleveraging, which would quash any notion of a swift swing back to spending. The average mortgage holder is 62% geared at a time the average rental yield (3.7%) is well below the mortgage rate (6.7%). The bond market is also telling us, CS notes, that it does not pay to take on duration risk.

Nor is momentum worth backing at this stage, say the quants. Even if we are reaching a turning point in the macro cycle, uncertainty remains in Europe and the US and uncertain times do not support the build up of momentum.

So tick off value, and tick off momentum trading, and should just leave “growth”. But the CS quants are not keen on growth either. They are only keen on “quality”.

“Quality works when we are contrarian and bearish,” they point out, “while growth works when we are contrarian and bullish”. While stock markets have begun to factor in a more positive view on world growth, bond markets are pricing in the opposite. Hence Credit Suisse favours a tactical switch to quality.

In this case, quality means defensivesness, exposure to US dollar earnings and selected large-cap miners. Hence Telstra ((TLS)), Aristocrat ((ALL)), Coca-Cola Amatil ((CCL)), Woolworths ((WOW)), James Hardie ((JHX)), Cochlear ((COH)), CSL ((CSL)), Brambles ((BXB)), Amcor ((AMC)), Aurora Oil & Gas ((AUT)), Iluka ((ILU)), Perseus ((PRU)), Orica ((ORI)), Fortescue ((FMG)) and BHP Billiton ((BHP)).

Credit Suisse should be able to buy a few of those from Citi.

The CS quants are not keen on smaller miners/energy or domestic industrials, including Alumina ((AWC)), Whitehaven Coal ((WHC)), OZ Minerals ((OZL)), Arrium ((ARI)), Oil Search ((OSH)), Sims Group ((SGM)), Santos ((STO)), Qantas ((QAN)), Echo Entertainment ((EGP)), Boral ((BLD)), Boart Longyear ((BLY)), and QR National ((QRN)).

Picking up on the US dollar earnings theme, and the building materials sector in particular, UBS notes medium term confidence in the US building sector is improving which is driving higher prices for James Hardie and Boral. In the meantime, Australian expectations remain in the doldrums.

UBS expects the sector will “stay expensive and volatile” and believes any upside surprise will have to come from Australia, in which confidence remains low, rather than the US, in which confidence has improved. At present, the UBS analysts have set earnings growth forecasts in FY14 of 18% for Fletcher Building ((FBU)), 28% for James Hardie and 40% for Boral. But slow Australian construction remains a threat to these estimates, the analysts admit.

However a sustained US recovery will generate a “material” earnings uplift, UBS suggests, for those stocks with US exposure. Putting it all together, UBS has a Buy on Boral but a Sell on James Hardie, seeing the latter as too expensive right now. Adelaide Brighton Cement ((ABC)) offers less upside than JHX but reasonable value, so it scores a Buy. The same is said of Fletcher on the value front, hence Buy, while CSR ((CSR)) sits in the middle on Neutral.

Goldman Sachs has changed the way it calculates mining company target prices. The analysts now specifically evaluate exposure to key risks and discount underlying fundamentals accordingly, thus deriving targets which more accurately reflect the overall risk environment, they suggest. This is particularly appropriate for juniors with underdeveloped assets. 

Without going into detail, the result is a downgrade for Sandfire Resources ((SFR)) to Neutral from Buy, and a downgrade for Lynas Corp ((LYC)) to Neutral from Buy. Independence Group ((IGO)) sees its Sell rating maintained but Goldman has removed IGO from its Conviction List.

Replacing IGO on the Conviction List with a Sell is Western Areas ((WSA)), while OceanaGold ((OGC)) and Fortescue have both been added to the Conviction List with Buy ratings.
 

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