The Year Of Growth And Reduced Liquidity

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By Rudi Filapek-Vandyck, Editor FNArena

Here's my first confession for the new calendar year: I cannot help but pull a funny face every time I hear an economist or share market commentator declare 2014 will be a good year for equities because global economic growth is expected to finally accelerate, with the US resuming its global leadership.

For starters, and as is easily shown via comparative price charts for the years past, there is no historical correlation between economic growth and share price performances. In fact, more often than not, it's quite the opposite in that negative economic performances often provide cheap share prices and thus undervalued buying opportunities.

Some analysts put this lack of correlation down to the fact that equities always try to forecast the next stage in the economic cycle and this means -all else being equal- that this year's economic resurrection has already been priced in during the uninterrupted rally of 2013. Any investor buying today because the US economy, and its global impact, are looking forward towards a better performance this year is at least six months late to the party.

This also explains as to why there have been so few noticeable pull backs since mid-2012. The global rally in equities -predominantly those in developed markets- has been all about improving investor sentiment and very little about growth in shareholder profits, at least outside the US. Inside the US, corporate boards have been masters in keeping costs down, using the advantage of a weaker USD and low interest rates and employing excessive cash to improve shareholders' appetite for more.

The big question mark for the US share market is whether historically high profit margins can be sustained, or even further increased, instead of falling from current "peak" levels. If the latter proves to be the case and an improving US economy sees the Federal Reserve further withdraw its monthly monetary stimulus, watch out.

As I repeatedly pointed out last year, the mantra that an improving global economy by default means better shareholder returns is a widely quoted misconception; too easy in its thesis and mostly in contrast to what history actually tells us.

My personal approach is that investing in the share market is ultimately all about profit growth (note: not profits per se, but growth in profits) and reason number one as to why 2014 was always going to be a tougher year than 2013 is because after the improvement in sentiment, which has caused PE ratios to expand, further upside must eventually come from priced-in expectations to show up in company results releases.

Here the expectations for corporate profits in Australia have been improving leading into 2014, which supports the view that equities will put in a positive performance this year, but the shorter term is likely going to be a lot less straightforward.

In practical terms this means paying attention to "risk" remains necessary in order to avoid short term value traps in today's full-of-anticipation share market. My gut feel is that low interest rates, normalising consumer spending, a weakening currency and corporate focus on cost-out policies combined are feeding the next upturn in Australia's profit growth cycle, but also that February might prove a little too soon for many local companies.

This means profit disappointments a la ResMed  ((RMD)), Super Retail ((SUL)) and The Reject Shop ((TRS)) are going to be more common than investors would like. Declines in share prices post such disappointing releases will only prove genuine buying opportunities if growth slows, not disappears, and if we all truly can believe the underlying trends remains up.

Within this framework I note all three of these companies' share prices are currently trying to find a bottom at lower prices. I'd be most cautious on The Reject Shop, while ResMed appears to be a case of "what is your horizon?" (shorter term competitive challenges versus long term growth) and Super Retail still enjoys too many groupies (and market confidence) to become much cheaper than where its PE multiple is today (4% implied forward looking dividend yield).

None of these companies can afford to disappoint again in August.

Internationally, it should be clear to everyone who's not blind that the super-charged growth in China is now truly and definitely an icon from the past. In fact, if there is one observation that doesn't seem to have gained much ground just yet it is that it appears the Chinese economy requires fresh support just about every year now to stay within the governments objectives.

I think we will see yet more stimulus being implemented later this year, apart from the fact that slower growth and tougher government policies will increasingly bring out internal weaknesses. On top of this, I believe the "unintended consequences" of Fed stimulus reduction I consistently warned about last year is going to keep investors' attention focused on Emerging Market risks this year.

In essence, Emerging Markets have become the new Europe and we can all start preparing for reductions in growth on the back of higher interest rates and other protective measures in countries such as India, Turkey and South Africa.

Volatility guaranteed thus!

I remain of the view that supply is plentiful for most basic materials, including crude oil and iron ore this year, and this is going to keep a lid on price performances for commodities, despite the widely anticipated pick-up in global growth.

Where the situation will prove different is in share prices for resources stocks. Most have been sold down in extremes and a relatively flattening price outlook for commodities will allow share prices to "normalise" in many cases. Assuming there's no unexpected interruption to global demand, commodity prices could be in for a better outlook in 2015 (probably not for crude oil and iron ore, though) but in all likelihood this is what investors will try to anticipate in 2014.

Does this mean that mining services providers and gold producers are finally investment grade again?

I doubt it. There's little doubt in my mind that both sectors represent genuine bargains today and when we all look back in a few year's time, we are going to regret not having bought the right stocks at the right price. If only we could call up Harry Hindsight today and ask him about the future.

Some funds managers are dabbling in both sectors with risk-mitigating, sophisticated strategies. I still think the overall risks remain too high for most retail investors, so unless you have the capital and the nouse available to apply similar risk-mitigating strategies, and you do have the risk appetite that is required, I suggest investors stay away and simply bide their time and look for opportunities elsewhere.

One of the themes I see for 2014 is a resurrection of investor interest in oil and gas stocks. This despite the fact that crude oil prices may well start to trend lower. I believe that when Oil Search ((OSH)) and Santos ((STO)) start delivering gas from their PNG LNG project, this will put the focus firmly on the cash flows these operators will generate from such projects.

Excellent research conducted by analysts at Credit Suisse, with the focus on the next ten years, strongly suggests Oil Search is likely to prove to be the best performer in the sector. The stock has already proved to be the best sector performer -by a sizeable distance- in years past, so my guess is there's likely a direct correlation here. Special note: Oil Search is certainly not without risk.

Investors should keep an eye on Origin Energy ((ORG)) as the stock is arguably much cheaper priced and it receives a lot less natural coverage than the likes of Woodside Petroleum ((WPL)) and the abovementioned. Origin's management should stop the rot from excessive discounting in retail electricity next year plus it has its own LNG project maturing within the next 24 months. Add many a disappointed shareholder because the returns haven't exactly been stellar in recent years, and that's putting it mildly.

In general terms, I remain of the view that investors will do well by focusing on cash flows instead of profits and profit growth in the larger cap resources space. Woodside shares have remained inside a relatively tight range since announcing it had effectively turned itself into a dividend play (albeit with questionable longer term prospects).

Shares in BHP Billiton ((BHP)) have now returned back to levels that are close to 4% implied dividend support for the year ahead. Historically, this has proved time and time again a relatively safe entry point with sharply reduced downside potential. This is because analysts may quibble about what next year's profits might look like, and which segment will outperform others, but virtually no one doubts the group's cashflow potential and thus continued increases for dividends in the years ahead.

If anyone wonders why BHP shares found support around $31 last year and they are now finding it around $36 then look no further than the weakening Australian dollar. In mid-last year, 4% dividend support was located at circa $31, now it sits at around $36. Don't expect to see BHP shares back near $31, not without anything happening to current cashflow and dividend projections (or to the AUD).

By the way: everybody with a paid subscription can access this information in real time via Stock Analysis on the FNArena website.

Given the changing dynamics for resources stocks this year, I have a firm suspicion BHP shares on dividend support will prove a good benchmark (high correlation) for the higher quality smaller players in the sector in general (but not for the speccies): stocks like Western Areas ((WSA)) and Independence Group ((IGO)). This gives investors one more reason to pay attention as to when BHP shares approach that 4% support level this year (they do now).

And the banks? I hear you all ask. The banks remain expensive, there's no two ways about it, and all bank share prices have deflated a little since the last dividend payments by all except CommBank ((CBA)). The subdued start into the new calendar year has by now pulled all the Big Four share prices below consensus price targets and this is something we truly haven't seen for a while.

Also, CommBank shares below consensus target has over the past year proved a good entry point, not just for CBA shareholders, but for the sector in general. Further out, I share the concern that all the tricks employed by the sector in recent years to keep those dividends growing by might and force shall at some point translate into payback time.

I don't think this will happen this year, when volatility is likely to spike and when banks announce further dividend growth, but consensus forecasts are for negative growth in Westpac ((WBC)) dividends in FY15 and this is certainly that should be on every shareholder's radar. Negative growth effectively means analysts think Westpac might actually cut its dividend that year, albeit in minor form.

I wouldn't be surprised if the surprise package of the year will be old media companies, hot on the heels of bricks and mortar retailers in 2013.

Lastly, for the stock pickers out there that are always on the lookout for a new idea, I have been unable to figure out as to why shares in Flexigroup ((FXL)) have fallen from $5 to below $4 in January. On this basis, and given the shares have now effectively returned to 4% dividend yield (4.4% in FY15), I suspect this might have opened up an opportunity for a standard diversified portfolio.

Sheer irony, also, to watch all those bullish market experts trying to denounce the annual January Indicator. My analysis, years ago, showed the January Indicator is nothing more than mass-delusion. It's that we want to believe that, somehow, the first five trading days of the new calendar year are a sign of what the rest of the year will bring.

I'll tell you what this year's price action in January means for the outlook in 2014: it's going to be a lot less straightforward, interspersed with a lot more volatility and returns at the end of the ride are unlikely to match the ones from last year. By the end of the year, equities will still be more likely better performers than most alternatives, if only for the fact that government bonds remain a no-no and local properties are going to feel the pinch from rising interest rates at some point.

It's good to be back. Looking forward to servicing you all over the next eleven months (and beyond, of course).

(This story was written on Monday, 03 February 2014. It was published on the day in the form of an email to paying subscribers.)

(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)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July this year forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet was released in January this year and is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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