Weekly Broker Wrap: Demand For Yield Persists

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-Best opportunities for investors
-Capital returns most likely
-Diversification the key in picking E&C contractors
-Improving conditions for airlines
-Is the RBA being tardy in cutting the cash rate?
 

By Eva Brocklehurst

Demand for yield has dominated equity markets for most of the past two years. Interest rates are expected to remain low and Goldman Sachs expects investors will continue to reward companies returning capital against those that re-invest earnings. This should persist until there is more definite evidence of a recovery in growth. There is little room for further yield compression in the defensive, income-generating sectors as pay-outs are already high and, in some cases, dividend risks are mispriced in Goldman's view. The best opportunities are with companies that have conservatively managed their capital, despite the scope to increase cash returns. The broker believes the market response to the recent Woodside Petroleum ((WPL)) pay-out announcement suggests that short-term increases in returns to shareholders can be sufficient to drive a strong re-rating.

Cyclical industries dominate the list of stocks where cash returns are low, unsurprising given the recent earnings volatility. The broker's forecasts are for growth recovery in late 2013/early 2014 and this could see some names generate strong cash returns with accelerating earnings growth and rising pay-out ratios. Stocks that rank highest on Goldman's capital management scorecard include BlueScope ((BSL)), Lend Lease ((LLC)), Fairfax ((FXJ)), Beach Energy ((BPT)), Qantas ((QAN)), Origin Energy ((ORG)), Rio Tinto ((RIO)), Challenger Financial ((CGF)), Newcrest Mining ((NCM)) and JB Hi-FI ((JBH)).

On the other hand, many defensive stocks that have led the recent market rally are on the list of those for which pay-out ratios look stretched. Goldman worries about the valuation risk in many of these stocks as yields have compressed and dividends are potentially unsustainable. Companies are cautious and tactical capital returns, such as special dividends and buy-backs, are likely to be favoured over an increase to ordinary dividends. Goldman notes the market typically expects ordinary dividends to be a multi-year commitments. Moreover, the low borrowing costs with equity valuations at long-run average should make buy-backs earnings accretive for a high percentage of companies.

Goldman notes stocks with low levels of leverage include OZ Minerals ((OZL)), BlueScope, Downer EDI ((DOW)), Iluka Resources ((ILU)), Flight Centre ((FLT)), Wesfarmers ((WES)), Echo Entertainment ((EGP)), Cochlear ((COH)), PanAust ((PNA)), Carsales ((CRZ), Graincorp ((GNC)) and Lend Lease.

Goldman also asks the question as to whether the industry heavyweights will shift course. The broker attaches a low probability to the big miners significantly lifting pay-out ratios in the short-term, given the lack of visibility on commodity prices and a high level of maintenance capex. Debt-funded buy-backs are considered most likely because of the low leverage, heavily discounted UK listings and ability to lock in long-term funding at extremely low levels. Major banks may have room to lift pay-out ratios but the broker thinks special dividends are more likely, given uncertainty over capital standards and a soft credit environment. Commonwealth Bank ((CBA)) and Westpac ((WBC)) are best positioned for this.

The infrastructure and utilities sector has performed strongly in recent years and Goldman takes a backward-looking punt on picking winners, back-testing the predictive power of valuation metrics and financial data over FY00 to FY12. Among the lessons learned is that valuation-based stock selection works. Many of the metrics tested that generated positive returns achieved compound returns of over 10%. Another lesson is that selecting stocks based on distribution yield plus growth generated the strongest risk-adjusted performance.This strategy yielded compounded average returns of over 23% per annum for top quartile stocks.

Which stocks offer the highest current dividend yields in the infrastructure and utilities sector? Goldman notes Sydney Airport ((SYD)) and Spark Infrastructure ((SKI)). Those which offer the strongest forecast prospective dividend growth profiles are Spark, Australian Infrastructure ((AIX)) and Transurban ((TCL)).

For CIMB, a significant rise in costs is diminishing returns for asset owners in the engineering and contracting segment. Demand is not really the problem, as peaking activity has been well flagged and still remains well above historical levels. Rising costs will need to be shared or removed to ensure developments are viable. At best, CIMB thinks margins will be squeezed and those unable to assist clients in reducing costs will most likely be removed or replaced as a contractor. As an aside, the broker does not consider this is a specific problem for mining services but rather for all sectors.

For the contracting and engineering services, diversification by industry, geography and service should reduce economic impacts but won't entirely shield industry participants from the adverse effects of a downturn. A lot of earnings risk is already factored into share prices and attention should turn to emerging value. CIMB prefers companies which show diversity in international business, commodity type and service area. As a material improvement in Australian costs is unlikely in the near term, the broker urges caution across all Australian-focused engineering, construction, contracting, capital goods and other related service providers. Picking the bottom of the market will be difficult so the broker suggests an accumulation strategy. Preference is maintained for companies such as WorleyParsons ((WOR)), Ausenco ((AAX)), ALS ((ALQ)), Cardno ((CDD)), and Clough ((CLO)) for oil & gas exposure.

Traffic statistics from the airlines show domestic market capacity only grew by 3% in March. This means improving capacity restraint, according to UBS. Daily production of available seats has also consistently fallen on a sequential basis over the last six months. UBS thinks it is increasingly likely that Qantas and Virgin Australia ((VAH)) will cut the 5-7% capacity growth forecast for the June half year and generate positive yield in the June quarter. The broker notes that every 1% extra domestic unit revenue equates to $80m per annum extra pre-tax earnings for Qantas and $30m for Virgin. Jet fuel (Singapore benchmark in AUD) has dropped $15/bbl to $115/bbl since both companies reported in mid February. The broker thinks both airlines will benefit form improving operating conditions in the domestic market and easing fuel costs. Qantas remains the preferred pick on valuation and near-term momentum.

Macquarie took a look at reasons behind why the Reserve Bank of Australia has been reluctant to cut rates in recent years. Maybe the central bank wants Australians to save more and encourage firms to address weak productivity growth. The analysts believe this is desirable, and perhaps inevitable, but it's a painful process nonetheless. Household spending is not expected to resume the growth it enjoyed in the 1990s for some time yet. Macquarie takes a look at what Germany went through earlier this century. It took about five years for the benefits of the German reform process to outweigh the costs imposed. Monetary policy was not the key driver of the reforms either, but it did play a role in the background. The European Central Bank was reluctant to cut rates too far in 2002, creating an environment more conducive to reform, and then a spurt of rate cuts in 2003 helped offset some of the short-term negative effects. It meant reforms, when they were introduced, had a better chance of succeeding.

In the analysts' view the case for a cut to the RBA's cash rate in May is clear. Underlying inflation is running at the bottom of the 2-3% target band. The RBA expects growth to decelerate below trend over 2013 and for unemployment to rise further, which suggests that inflation will slow further from here. The strong currency continues to inflict pain on the tradeable goods sector of the economy. Despite that, markets are far from convinced of the likelihood of a May rate cut. If that's correct, and the central bank is keeping its powder dry, then there are some sobering implications for growth and the economy over the next couple of years, in Macquarie's view. When firms all focus on cutting costs to improve margins and profits it is likely to result in subdued growth, weak investment and rising unemployment. Where the economists differ from the RBA in characterising the situation for the year ahead is over the persistence of this softening in activity.

Returning to Germany, the ECB cut rates in two stages, initially cutting from 4.75% to 3.25%, waiting a year, then cutting again to 2%, leaving rates at a steady state then for a couple of years. Macquarie believes the ECB was channelling Germany's Bundesbank, which successfully dealt with a high inflation era 40 years ago. The RBA's original choice of the 2-3% inflation target was partly influenced by the success of the Bundesbank in keeping inflation in Germany around that level over the 1970s and 1980s. Also, Macquarie notes the RBA has consistently talked about the benefit of running growth (and inflation) a little weaker in the short term if it meant a more stable economy over the medium term.

High inflation is not a problem in Australia at present. Macquarie suggests that, once companies start cutting costs and improving efficiency, then the way in which monetary policy can assist that process is by preventing growth from falling too far. In Macquarie's view, action on the company side of the equation is now happening. This then suggests the RBA should become less reluctant to trim the cash rate.
 

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