Australia | Mar 07 2013
-Risk appetite elevated
-Earnings improvement to broaden
-Investor confidence increasing
-Industrials leading on expectations
By Eva Brocklehurst
As the dust settles on another Australian earnings season the questions brokers are asking is… Where is the justification for current share prices going to come from? Which sector?
For Credit Suisse the Australian market is now expensive and risk appetite perhaps a little too elevated, while Citi expects a broadening of earnings improvement. Macquarie strategists think the investment community is showing increased confidence in valuations and is modestly upbeat about the growth outlook.
Citi notes December half results generally exceeded expectations for the first time in 12-18 months. While earnings are still likely to be flattish in FY13, the industrial (ex bank) sector is looking for moderate growth for the first time in a few years. This should be underpinned by strong growth in healthcare, rail transport, insurance and diversified financials. The broker also expects less weakness in contractors and retailers.
The positive trends are supported by improved operating conditions from lower interest rates, contributing to increased spending. In terms of quality of earnings, the question prevailing in the marketplace has been about growth driven by cost reductions rather than revenue, suggesting that in some sectors prospects are still poor. Citi finds three reasons to be cheerful. Low expectations heading into the results were not all-encompassing. There were some sectors/stocks that justified their valuations. Cost cutting, while widespread, is not a temporary event designed to gee up the bottom line. Many companies have targets for reducing costs through to FY15-16, as well as for divesting assets and streamlining businesses. All these aspects have the potential to support earnings growth over the next few years. The broker believes that, after 20 years of economic expansion, there is likely to be considerable excess to trim. The third reason is revenue improvement in some areas is picking up, helped by lower interest rates.
Some of the contradiction between cost cutting for earnings growth and revenue growth is partly due to of the composition of the market. Citi notes stocks in the industrial (ex bank) group account for less than half of the market cap while resources and banks make up more than half. Within the industrial (ex bank) group, other financial stocks make up a further significant proportion: insurance, diversified financials and real estate investment trusts. As a result, the non-resource, non-financial stocks are only one third of market cap and this is where earnings growth has been weaker and, in many instances, driven significantly by cost cutting. Citi also notes the revenue slowdown was exacerbated by a drop in gaming stocks, as the Victorian licences were lost. Otherwise, it was concentrated in the resource-related sectors such as contractors and chemicals. The broker expects revenue growth to improve in areas such as retail and media, as spending outside of resources responds to lower interest rates.
Macquarie finds investors' strong risk appetites are underpinned by the need to reallocate capital to higher returning assets and away from cash. While lower earnings growth rates may be a feature of the post-GFC environment the broker is confident earnings have reached the bottom of the cycle. The broker's measure of total annual shareholder return is forecast at 8.6%, which includes a capital return of 4% and dividend return of 4.6%. Therefore, Macquarie's fair value index target for the S&P/ASX 200 is 5308. The index has already put on over 10% across the last two months but Macquarie's analysis suggests there is still modest upside.
Credit Suisse differs, in that the broker expects risk appetite to wane. The broker's risk appetite indicators show the market slightly stretched from a momentum perspective. The concern is over the global growth momentum, to the extent that a slowdown could be exacerbated through one or more of several risk factors. These include US consumption declining from increased payroll taxes, sequestration or higher gasoline prices, a negative response to the Italian election or policy changes in China. Moreover, Credit Suisse is still not convinced a significant recovery in Australian economic conditions is in train. Therefore, policy, just as much as earnings, will drive domestic cyclical stocks. As long as the RBA shows willingness to cut the cash rate further, without actually cutting, domestic consumers and employers should maintain some level of spending by reducing savings rates. This is not enough to guarantee the sustainability of risk levels for the broker over the near term.
The weakest outlook is for mining services as data shows the capex pipeline is subdued. For Credit Suisse, valuations are not reflecting this weakness. Resources earnings are being revised upwards but, while the outlook is more stable with cost management a greater focus, the sector is at the mercy of commodity prices. Credit Suisse thinks best valuations are in large cap lower cost producers. Global industrial stocks appear more optimistic but the broker notes the Australian divisions lagged in this respect, underscoring a more positive global environment relative to the domestic environment. Going forward, earnings should continue to show resilience relative to domestic cyclicals and, where valuations are attractive, Credit Suisse continues to have a preference for the sector.
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