A Risk Assessment For Australian Equities Anno 2013

This story features HARVEY NORMAN HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: HVN

By Rudi Filapek-Vandyck, Editor FNArena

There's a certain irony in the fact that retail investors in the US are starting to rediscover US equities now that major indices such as S&P500 and Dow Jones Industrials are back at levels not seen since late 2007. Funds flows into US equities are now net positive for six consecutive weeks. Previously, funds flows had been negative since the final quarter of 2007.

According to AMG Data, mutual funds in the US have been experiencing the largest two-week funds inflows since the year 2000 (before Nasdaq peaked and crumbled). Data compiled by EPFR Global suggest funds flows into global equities this January has been the strongest since late 2007, weeks before equities peaked at all-time highs.

Note that the Russell 2000 index, which acts as a barometer for small cap stocks in the US, had already set a new all-time high in the second quarter of 2011. That record high has now been broken.

Anecdotal evidence suggests a similar process is taking place in Australia with overall activity in Australian equities picking up into the new calendar year. Here too the obvious irony is that sought-after bank shares, because of their solid and reliable dividends, could have been purchased at much more attractive price levels only a year ago.

The key difference between early 2013 and each of the five years that followed the late 2007-correction is, of course, that macro-related risks finally seem to have subsided. The US economy is no longer staring into the abyss. Europe is holding together. China is transitioning into the next phase. Central bankers around the world are feeding their economies with easy money. The reduction in macro-related risks has translated into a marked reduction in overall volatility. Rising prices at low volatility make for a much more accommodative environment to invest in. Hence it shouldn't surprise that the retail investor is finding his way back into equities.

But macro-risks and reduced volatility are only one side of the risk ledger associated with equities. There's also still valuations and operational risks and with equities in Australia having rallied a good 15% in 2012 (plus 5% in dividends on average) in a declining earnings climate, this looks like the right time to start asking questions about where the real risks are, on micro-level, and whether risk-reward is as finely balanced as one might suspect?

Firstly, history shows it is not unusual at this stage of the bear market-bull market cycle for equities that valuations return to more normalised levels. As valuations for riskier stocks in Australia have been depressed, this normalisation process in itself can have a profound impact in terms of share price appreciation. Investors who have been around for a while might remember the share market going through a similar process in 2003 and 2004.

Analysis conducted by Citi suggests the bear market that started in 2007 is now well and truly past its expiry date. In every precedent of the 20^th century Australian equities had by now been on the road to recovery, reports Citi. So it's about time!

A logical counter-argument is that history is one thing, but the future is something different. Even if equities are now clawing back the remaining losses since 2007, it's not necessarily going to be smooth and straightforward. Besides, share prices for some stocks are already well beyond levels of 2007, while valuations for others look pretty bloated in the absence of earnings growth finally materialising. So what gives?

Below is a micro-level risk assessment of the Australian share market as I see it at the start of calendar 2013. In descending order (highest risk first):

– Battling Structural Decay

Valuations for stocks such as Fairfax Media ((FXJ)) and Harvey Norman ((HVN)) have been thrashed during the bear market and a small improvement in the trading environment or a shift in board policies can potentially have a significant impact on the share price. Observe, for example, how the share price of Fairfax has already rallied from $0.36 in October to $0.55 by January. That's a gain of no less than 52%. Shareholders in Billabong ((BBG)), yet another company in a similar position, have seen the share price surge from $0.74 to above $1 on potential interest from private equity.

There's a saying among hardened investors that ultimately all the risks are priced in, plus some, and thus the only way is up. This suggests that "price" eventually reverses "risk". While this may well be true for the share market in general, it is hard to ignore that traditional media companies and bricks-and-mortar discretionary retailers are presently fighting for their lives. Some of today's household names in these sectors may not be around in their present form in five years' time – or not around at all.

Changing consumer behaviour, rapidly changing industry dynamics, new technologies, the destructive impact the internet has on traditional business models… the downtrodden, trashed, structurally challenged champions of the 20^th century may appear ideal for a quick gain under the right short-term circumstances, but for investors with a medium to longer term horizon: why would you ever consider taking on board this level of risk?

– In La-La Land

Whether it's a biotech with years of research and development in front of it and no immediate prospects of revenues, or an exploration company sitting on a piece of dirt in the middle of sunburnt nowhere; during times of excessive risk appetite every listed security becomes a viable candidate to attract investors' attention. What the past years have also shown is that risk appetite is a feeble thing. It can disappear just as rapidly as it arrived and when it does disappear, watch share prices dive and volumes dry up.

This is the part of the share market where literally everything is possible. It's where dreams are kept alive and where fortunes go missing. If we are heading into a period of elevated risk appetite, no doubt there will be more examples of micro-caps whose name nobody ever heard of, that manage a gain of 1000% in a short time. There will be many more peers that end up going the opposite direction. Explore only with the correct attitude towards risk.

– Milestone Companies

This is effectively the upgrade section from La-La Land. This is where biotechs upgrade themselves by accumulating positive trials, working towards the development of an approved new medicine. Ditto for miners and energy explorers that manage to get a project on the rails, securing partners, financing and infrastructure to start digging and transporting whatever valuables are located under the surface. Share prices are still very much inspired by investor sentiment, but this becomes less so as deadlines draw nearer and prospects for sales and profits become more tangible.

History shows the best gains may well be on offer when all the company has to do is reaching milestones, not after it has become an actual sales and profits generating entity. Shares in uranium producer Paladin Energy ((PDN)), for example, surged as high as $10 in May 2007 when the company was no more than an emerging, potential future producer of uranium. By November last year, Paladin's share price had sunk as low as $0.765. In similar fashion, shares in biotech Mesoblast ((MSB)) reached as high as $9.67 in 2011. The company is today arguably further advanced in its corporate development, yet the share price is now below $6.

Other examples are Fortescue Metals ((FMG)) whose share price peaked above $13 in 2007. Today it is trading near $4.50. Lynas Corp's ((LYC)) share price traded above $2.50 in 2011, they are now at $0.63.

To be explored only with the correct attitude towards risk.

– Come-back and Turnaround stocks

This is arguably the section that represents, on a relative risk-reward assessment, the highest potential in the Australian share market.

When stocks are abandoned and ignored, valuations fall to depressed levels. Stocks can fall out of favour because of stock-specific reasons. Having a few bad years? A scandal or two? Bad management decisions? The wrong acquisition that comes back with a vengeance? Stocks can also fall out of favour because of sector-related issues. In both cases, depressed share price valuations offer significant potential when the turnaround arrives.

One obvious sector that has seen more shade than sunlight these past few years are property developers and building materials stocks. RBA rate cuts and improving data on the US housing market have re-ignited investor interest since the second half of last year and share prices have run hard, making valuations appear full if not overpriced on short term profit expectations. If you are not already on board you now have to bank on upside surprises and there's plenty of potential for such surprises on a 2-3 years horizon. Because profit margins have been under tremendous pressure, a little relief can make a huge difference in years ahead. Under positive scenarios, companies such as Boral ((BLD)) and James Hardie ((JHX)) can potentially double their profits over 2-3 years ahead, but this requires ongoing positive input from housing markets in the US and in Australia.

There is the risk the huge potential materialises at a slower pace than currently hoped for by investors. One way to deal with this risk is to adopt an investment horizon of at least 2-3 years.

Other obvious come-back stocks are miners and energy companies. Both have had a genuinely rough time since the opening months of 2010 and many of the better quality stocks in these sectors have not generated much in terms of investment returns since 2006 (six long years ago); if they have generated any net returns at all. A small step upwards in Chinese/global demand can make a significant difference for these stocks, at least in the short term. Share prices have rallied double-digits since the trough in 2010, but, again, investors not yet on board have to take the view there's more room for upside surprises and the built-in leverage will do the rest.

It's probably good to keep in mind this is not going to be a repeat of 2004-2007, or even of 2009-2010. Assuming otherwise would be reckless. Spot iron ore prices may have surprised to the upside in the short term, they're still heading for sub-US$100/tonne levels in 3-4 years' time. Other commodities that seem poised for surprises to the upside in the short term include copper, platinum and molybdenum.

Most commodities will be battling a supply response in the year(s) ahead, if they haven't already (see: coal markets, nickel and mineral sands). This also applies to crude oil prices which have remained in a rather tight trading range throughout 2012. This year and possibly even next year seem poised to deliver more of the same, in the absence of geopolitical stresses or supply disruptions. This means that stock-specific characteristics will be all-dominant for most commodity segments in the share market. Investors should look for producers with strong potential, regardless of product price support, that are likely to achieve project deadlines and production targets at sustainable margins.

In the short term the odds seem skewed towards more upside surprises, but there is the risk that future potential might be less, shorter or slower, which can have material impact on share prices.

Probably needless to highlight but despite a general bout of optimism since late 2012, the global economy has yet to find a solid footing without support from excess easy money and ultra-low interest rates and these come-back stocks do need ongoing improvements to deliver on their full potential.

Not all beaten-down stocks are in the same position just yet. Services providers to the mining sector still have the challenge of a general decline in capex in front of them. A profit warning from gold miner Perseus ((PRU)) at the start of the year and another one this week from Sims Metal Management ((SGM)) -with added write-downs plus impairment charges- can serve as a reminder that risks at the bottom of the valuation table remain elevated still. Conversely, announcements of lay-offs by Boral and Iluka ((ILU)) were received as a positive by investors.

– Steady Dividend Payers

Most stocks in this category have enjoyed an excellent run from 2011 onwards. Valuations are now as high as they've been post-2007 and on a relative basis, vis-a-vis the riskier stocks, valuations look stretched on historical comparisons. All of this is not a problem if your prime focus lies with solidly growing, sustainable income from dividends, but what if you're not on board yet?

There is a risk that, because of elevated valuations, share prices at some point might come off and create a temporary set back in total returns for the short term. Alas, the market is not necessarily going to facilitate a correction tomorrow so that you, latecomer, can  also step aboard at a more convenient price level.

If you have to get on board now the most logical way to reduce risk is by adopting a longer term horizon. If those dividends keep coming, and grow higher in years to come, the share price will eventually recover and appreciate higher. It's probably the most valuable lesson history can teach us. (see also P.S. below)

– In The Sweet Spot

Some companies are in an operational sweet spot which virtually guarantees a continuation of strong growth numbers that have rewarded loyal shareholders in years past. Think Breville Group ((BRG)). Think Super Retail ((SUL)), but also The Reject Shop ((TRS)), Amcom Telecom ((AMM)) and Technology One ((TNE)). It's good to keep in mind being in a sweet spot is not going to last forever, but while it does investors at least have a few things less to worry about while enjoying the benefits from continuously strong growth.

As the market has by now caught up with the strong growth that is on offer, valuations can be a problem, but then these stocks are unlikely to ever become genuinely cheap again, unless the market sniffs an end to the golden period. Buying on dips seems but the logical strategy if you still want to get on board.

– All-Weather Performers

It doesn't really matter whether Europe will have a longer drawn-out recession, or whether the RBA will further lower interest rates, or whether China can re-balance its economy on time in the years ahead; there's a small selection of stocks that will perform regardless. It's their second nature. It's what comes naturally for these All-Weather Performers.

These stocks won't necessarily end up in the top ten of best performers in any given year, but they do perform and reward shareholders on a consistent basis. Valuations are not cheap, with exception of possibly Retail Food Group ((RFG)), but loyal shareholders know the value of consistent and reliable performance. They can remain confident the years ahead will simply offer more of the same.

It has been and still is my view that stocks such as McMillan Shakespeare ((MMS)), Amcor ((AMC)), Domino's Pizza ((DMP)), Ramsay Healthcare ((RHC)) and Coca-Cola Amatil ((CCL)) should be on every investor's radar, all the time. Because inside a long-term perspective, and amidst ongoing macro-economic uncertainties, these stocks offer solid rewards at the lowest operational risk. Just gotta keep an eye on valuations.

(This story was written on Tuesday, 22 January 2013 and published on that day in the form of an email to subscribers).
 

Best Wishes for the New Year to you all. May 2013 bring success and prosperity.

(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) 

P.S. At face value, the ASX200 index in Australia is still some 44% below its peak from early November 2007. However, CommSec's Craig James has calculated that on a dividend adjusted basis, the remaining gap is only 12%, once again highlighting the importance of steady, increasing dividends for investors with a longer term focus.

****

Rudi On Tour in 2013

– I will visit Melbourne in February for a presentation on invitation by the local AIA branche. Title: "The Big Confusion that is the share market". When: Tuesday 19th February 2013. Where: Telstra Conference Centre, Level 1, 242 Exhibition Street, Melbourne

– I will visit Perth in March for two presentations on Tuesday March 5 (AIA) and on Thursday March 7 (ASA)

Click to view our Glossary of Financial Terms