Treasure Chest: Equity Strategy Updates

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By Greg Peel

Stocks in the US and Australia have now taken a tumble off a cliff – this cliff being the fear of the other “cliff”. Up to the US election, markets were reflecting expectations of an acceleration in global growth and an end to persistent corporate earnings forecast downgrades, Deutsche Bank suggests. The Deutsche strategists have not changed their risk profile, but believe risk is now tilted to the downside.

Leading indicators point to a continuation of modest growth in the US and a recession in Europe, while China remains less clear, Deutsche suggests. As to whether there is enough here to drive commodity prices higher is thus not clear either. The strategists have been focusing heavily on Australian market PEs of late (See: Are Oz Stocks Cheap Or Expensive?) and had already decided the miners were expensive. Deutsche prefers energy. There is less likelihood of lower energy prices, energy sector valuations are historically low and concerns over a US shale gas deluge are overdone in Deutsche's view.

Defensives continue to attract around a 10% PE premium and Deutsche believes that's justifiable. Cyclicals offer better value on a multi-year view but as to whether earnings can pick up is again unclear. The strategists are feeling a little more confident given the RBA's focus on finding a new economic driver to replace the fading mining boom. Housing is looking a little better and Deutsche believes further RBA rate cuts will provide support for housing, but not for consumer stocks while the jobs market appears to be under pressure. The strategists have shifted their sector weighting on building materials to Overweight from Underweight.

With yields on bonds and term deposits under continuing pressure, Deutsche believes marginal investors will find equities attractive. The strategists have been playing Overweight banks to support this view but after strong performance are shifting their preference to listed property.

Macquarie has updated its conviction list for local stocks, which it calls Marquee Ideas. Macquarie has become more an more focused on “pairs trades”, in which a trader plays off one stock against another of the same sector in long/short positions. Pairs trades are not always accessible to smaller investors given the cost of shorting.

In Macquarie non-paired positions, nevertheless, success has been had to date with long positions in REA Group ((REA)), David Jones ((DJS)) and CSL ((CSL)) and a short position in Cabcharge ((CAB)), all of which are retained in the list. Alas, the Macquarie analysts had just undertaken a tour of the US and UK after which they decided to remove QBE Insurance ((QBE)) from the list but the company issued its profit warning while the analysts were somewhere over the Pacific. Too late, she cried.

The analysts have not removed their serial underperformer from the list – a long position in Newcrest ((NCM)) – but have now cashed in a good run with Charter Hall ((CHC)) which is now removed.

New pairs additions are long Toll Holdings ((TOL)) / short Asciano ((AIO)), long Woolworths ((WOW)) / short Metcash ((MTS)), and long ANZ ((ANZ)) / short National ((NAB)). The latter replaces long ANZ / short Westpac ((WBC)). Remaining on the list are long Fortescue ((FMG)) / short Atlas ((AGO)) and long Monadelphous ((MND)) / short ALS ((ALQ)).

Macquarie analysts have also been to China (they do get around a bit) to have a look at tiles. They found a Chinese tile manufacturing industry running at low capacity utilisation and as such expect zircon prices to remain under pressure well into 2013. North American pigment producers are also running at low capacity, the analysts note, meaning no joy for titanium oxide prices either. Put it together, and Macquarie has downgraded Iluka ((ILU)) to Underperform.

Speaking of underperformance, the net market strength posted in Australia this year, so far, has been all about the big caps. Small caps have been left in the dust. While this might suggest value to be had in the smalls, UBS warns the macro signals that are historically good for small caps are yet to appear. UBS sees small caps either underperforming or, at best, equal-performing with the large caps from here.

Having said that, “small caps” as a single asset is one thing but that asset is made up of many individual stocks with differing outlooks. In the small cap space UBS' key picks are Ardent Leisure ((AAD)), Beadell Resources ((BDR)), Cardno ((CDD)), Charter Hall, Envestra ((ENV)), Fletcher Building ((FBU)), Mermaid Marine ((MRM)), ROC Oil ((ROC)), SAI Global ((SAI)) and Sandfire Resources ((SFR)).

Citi agrees that “near term triggers are hard to find,” given the “cliff” is now winding back the “risk on” trade. Citi thinks the earnings downgrade cycle still has further to go but the analysts are now warming to the idea of being dedicated followers of fashion. Hence in the small space, Citi likes Billabong ((BBG)) and Specialty Fashion ((SFH)), both of which carry Buy (High Risk) calls from the broker.

The small cap average PE of 11.4x has not changed during the AGM season and while “cheap” historically, is not quite so cheap relatively. Citi sees defensives as expensive and resources as a better bet than industrials for the most part. That said, Citi likes Flight Centre ((FLT)), Miclyn ((MIO)), MacMillan Shakespeare ((MMS)), M2 Telecommunications ((MTU)), and Southern Cross Media ((SXL)) along with Ausdrill ((ASL)), Gryphon ((GRY)), Karoon ((KAR)), Mt Gibson ((MGX)), Medusa ((MML)) and Resource Generation ((RES)).

Goldman Sachs has also been playing with the smalls, or “emerging companies”, and has just added St Barbara ((SBM)) to tits focus list in exchange for both Iress ((IRE)) and Mineral Deposits ((MDL)).

Goldman's emerging company focus list is currently all Buy-rated and includes, along with St Barbara, Ausenco ((AAX)), Ausbrokers ((AUB)), Carsales.com ((CRZ)), FlexiGroup ((FXL)), Henderson Group ((HGG)), iiNet ((IIN)), Kingsgate Consolidated ((KCN)), Kathmandu ((KMD)), MacMillan Shakespeare, OceanaGold ((OGC)), REA Group, SAI Global and Super Retail ((SUL)).

We began today's Treasure Chest with “cliff” concerns but we can end with a determined belief from Macquarie that “it will be resolved!”. Once resolved, the analysts see the flood of central bank liquidity to support rising equity prices while interest rates remain low.

It's the perfect storm for a Milken-esque bonanza, Macquarie feels (cheap funding and equity upside leading to leveraged buyouts or at least an upswing in M&A), beginning in 2013. Macquarie most favours US equities – particularly the banks and housing exposures – while remaining Neutral on Australia. The analysts see ongoing corporate interest in Australian resource stocks from the Chinese but actually favour industrials over resources from an M&A point of view. Australian companies with US exposure are preferred.
 

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