Post February Equity Strategy Recommendations

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This story features MACQUARIE GROUP LIMITED, and other companies.
For more info SHARE ANALYSIS: MQG
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

Deutsche Bank notes the February reporting season revealed flat earnings growth on a net basis for the Australian market. However, take out obvious weakness in the resource sector due to low commodity prices and the story is not so bad. Assuming pressure on commodity prices abates into next year then moderate net earnings growth is likely.

The market price/earnings ratio is running at around 16x, which is some 10% above Deutsche’s calculation of fair value. But the broker is quick to point out that a 10% deviation is neither uncommon nor particularly large. Given real interest rates (cash rate minus inflation) are close to zero, higher equity valuations can be sustained.

Only on individual stocks basis, volatility is nevertheless high, and stock analyst sentiment historically low. The broker suggests there are a couple of appealing themes but on balance, more worrying areas. Investors may need to round out their portfolios with stories that are “good enough”, Deutsche suggests.

The domestic housing sector remains appealing, being still short of historic peaks based on population growth despite having already run hard. Construction and prices for building materials are still on the way up. Offshore, jobs growth suggests the US recovery is sustainable, and the lower euro is improving confidence and credit growth in Europe.

Still worrying is that the large defensive sectors of consumer staples, telcos and insurers are seeing minimal earnings growth and increasing competitive pressure. Traditional yield looks expensive given high valuations, and in today’s market “traditional” yields are not much higher than yields available across the rest of the market. Iron ore miners continue to face the prospect of further pricing pressure. Supply continues to grow while Chinese imports remain flat.

That’s the good and the bad, so what’s the good enough?

The backdrop is reasonable for domestic cyclicals, says Deutsche. Interest rates are low and while business and consumer sentiment has waned, it’s at least around average. A decent economic backdrop is keeping the banks’ bad debt outlook in check, while credit growth is on the rise again as business credit demand ramps up. Those companies on the cost reduction war path are worth backing, the broker suggests, as margins should continue to improve from low levels. Energy offers long term value as US rig counts reduce and the oil price eventually overcomes near term supply.

Healthcare is one of the broker’s preferred sectors. PE ratios are not on the low side but earnings growth is solid. Utilities is the other preferred sector, given valuations look attractive. Deutsche also notes exposure to financial market names (eg wealth managers) is cheap vis a vis the market itself, and inflows are strong.

Morgan Stanley’s Favourites

Morgan Stanley also prefers asset and wealth mangers within the financials sector, ahead of domestic insurers and then banks.

The broker has an Overweight rating on Macquarie Group ((MQG)). The group’s business and geographical mix puts it in a good position to benefit from improving global operating conditions, low interest rates, rising asset prices and a weaker Aussie dollar. QBE Insurance ((QBE)) also attracts an Overweight rating as the company’s remediation nears completion and focus shifts to driving shareholder returns and growing dividends.

On the other side if the coin, Morgan Stanley rates Medibank Private ((MPL)) as Underweight. While growth is attractive in the health insurance industry, Medibank faces revenue headwinds, margins are now close to optimal levels and valuation looks stretched. ANZ Bank’s ((ANZ)) business mix and geographical exposure are creating downside risk to earnings forecasts, the broker believes, and ANZ is more vulnerable than its peers to increased regulatory capital requirements, hence Underweight.

In the wider picture, Morgan Stanley notes the February reporting season received a positive reaction from investors. However while the bulls suggest improving sentiment with regard earnings outlooks was the primary driver (that is, rising PE multiples), the broker suggests yield compression was really at play (investors paying up for yield).

More companies missed the broker’s earnings forecast than beat, and even more missed on the revenue line, highlighting that earnings growth was more about cost reduction. Balance sheets are nevertheless strong, hence most “surprises” came via dividends.

To that end, for how long can the market PE continue to defy flat market earnings growth and negative earnings momentum? the broker asks. The disconnect between valuation and earnings is “glaring”. The economy in general has been given a bit of a kicker from lower oil prices but beyond that, the tone is downbeat.

On the other hand, low interest rates and opportunities presented by the challenged domestic growth outlook have kick started a round of M&A and more may be expected. Retailers have begun to increase prices in some categories but more will be required, Morgan Stanley suggests, to protect margins.

Of those companies that posted solid earnings beats, and subsequently saw their share price run up, the broker suggests Domino’s Pizza ((DMP)), Tabcorp ((TAH)) and Super Retail ((SUL)) are three that are still worth buying.

M&A Theme To Re-Emerge

On the subject of M&A, Morgans (as opposed to Morgan Stanley) believes tepid economic growth and a low cost of capital mean companies will increasingly need to consider growing via mergers & acquisitions and through asset divestments, as well as reducing costs. The broker recommends taking positions in those stocks which are potential M&A targets and/or stocks looking to offload underperforming assets.

Three stocks Morgans finds interesting under such scenarios are Santos ((STO)), Oil Search ((OSH)) and BHP Billiton ((BHP)). With regard the two LNG players, the broker notes oil market volatility has historically driven sector consolidation as valuations between the strongest and weakest companies in the sector diverge. With regard BHP, the broker notes a history of demergers of assets which have ultimately evolved into significant companies in their own right. BHP’s intended South32 demerger may well attract M&A interest straight away, Morgans suggests.

The broker also notes the strengthening US dollar is encouraging North American resource sector service companies to acquire global peers. Solid franchises suffering from difficult markets may well capture attention. WorleyParsons ((WOR)) and Ausdrill ((ALS)) are examples.

Excess Cash Flows In Focus

Outside of M&A, Morgans notes prudent cost management and strong cash flow generation were once again dominant themes throughout the reporting season. Those companies converting excess cash flow into higher dividends or capital management (eg specials, buybacks) were rewarded the most. With interest rates set to remain low, these stocks are likely to continue to command premium ratings, the broker believes, and there is quite a list.

It includes Vita Group ((VTA)), Rio Tinto ((RIO)), Ansell ((ANN)), Tabcorp, Woodside Petroleum ((WPL)), Amcor ((AMC)), BHP Billiton, Asciano ((AIO)), CSL ((CSL)), Energy Developments ((ENE)), Alumina Ltd ((AWC)), Transurban ((TCL)), Suncorp ((SUN)), Oil Search, Seek ((SEK)), and Platinum Asset Management ((PTM)).

Goldman Sachs’ Favourites

Goldman Sachs has added Seek to its A&NZ “Sustain” list, which features those companies offering higher returns on lower volatility. Seek now operates the largest global online employment marketplace with dominance in Australia and strong positions in China, other Asia and Brazil. Seek offers high cash returns on capital and a track record of both accretive M&A and reinvestment in operations driving growth.

Goldman’s A&NZ Sustain list otherwise includes AMP ((AMP)), ANZ Bank, BHP Billiton, Brambles ((BXB)), Cochlear ((COH)), Commonwealth Bank ((CBA)) and Computershare ((CPU)).

Readers may have spotted that different brokers tend to be at odds over ANZ.

Credit Suisse’s Favourites

Credit Suisse does not have ANZ in its Australia Top Picks list, preferring National Australian Bank ((NAB)) instead. But CS has just added leisure property investor Mantra Group ((MTR)) to the list.

Mantra delivered a strong result in February but more importantly, the broker notes, the outlook has strengthened with new properties being added at a faster rate than expected and the pipeline of new property opportunities has grown. Mantra is able to self-fund through its capital-light model and scalable platform, and thus is in a good position to exploit new supply as the falling Aussie reinvigorates domestic tourism and increases inbound demand.

The broker suspects Mantra is entering an earnings upgrade cycle.

Credit Suisse also recommends a Long-Short portfolio, and the broker is pretty chuffed that last year it included iiNet ((IIN)) on the long side, suggesting the telco was an M&A target and the likely bidder would be TPG Telecom ((TPM)). Now that this premonition has come to pass, CS has removed iiNet from its portfolio and replaced it with Nine Entertainment ((NEC)), which is offering a strong free cash flow yield and should be a beneficiary of any changes in media laws.

On the short side, Credit Suisse has closed its position on Insurance Australia Group ((IAG)) following that stock’s underperformance of the index, noting it no longer looks expensive. It has been replaced by Iluka Resources ((ILU)), which rallied strongly post result on management’s expectations of a recovery in Chinese zircon/titanium demand. The broker is sceptical, expecting flat prices to the end of 2016.

Cit’s Small Cap Selections

Citi has been looking at small caps and has taken on board the low interest rate environment and subsequent demand for yield stocks in crunching some numbers. The broker looked for those stocks outside the ASX100 which offered a forecast return on equity greater than 15% and a forecast earnings yield greater than 5%.

In that list were Sandfire Resources ((SFR)), Western Areas ((WSA)), McMillan Shakespeare ((MMS)), Flexigroup ((FXL)), Beadell Resources ((BDR)), Sky City Entertainment ((SKC)), Spotless Group ((SPO)), Super Retail and Specialty Fashion ((SFH)).

iiNet was also on the list Citi published just before TPG announced its takeover bid.

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