Equity Strategy: Where To Invest?

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

Brokers discuss their portfolio preferences following a shift in investor perception during the September quarter.

– Equity inflows solid
– Portfolio rotation underway
– Quality expensive
– Defensives still at risk
 

By Greg Peel

Inflows

The first quarter of 2016 saw weakness in funds flows into the Australian equity market as investors coped with plunging commodity prices and fears surrounding European banks. Data released last week by the ABS confirms a recovery in funds flows in the interim. Throw in capital raising data from the ASX, and Citi notes flows into equities have returned to around the relatively healthy levels seen in recent years.

Yet consumer sentiment towards financial markets is lagging fund inflow numbers. Recent surveys reveal a lingering preference to save (term deposits), Citi notes, than to invest, despite record low deposit rates and relatively high dividend yields on offer.

Superannuation funds continue to account for the largest inflows. Foreign investment remains steady and solid, driven by the US and Japan. Where flows are patchy is within domestic non-super investment, which includes retail investors. This is no doubt where weak consumer sentiment is having its impact.

Consumer preference for saving rather than investing has risen back to levels last seen in the GFC. However, Citi suggests that given investing in this instance includes property as well as shares, recent caution towards a cooling property market is likely at play more than a fear of the stock market. To that end Citi further notes that the superannuation fund bloc includes self-managed super funds, the trustees of which are consumers by any other name. SMSFs have continued to display solid investment in shares.

Rotation

And why wouldn’t SMSF’s look to the share market in a low interest rate world? Here they can find solid yield at relative safety. Hence the past couple of years have featured strong gains for the so-called “bond proxy” stocks – utilities, infrastructure funds, real estate investment trusts and telcos – and for the high-yielding banks.

The banks have had their own issues to deal with in 2016 but the September quarter saw the majors reasonably well supported. By contrast, investors have been dumping their bond proxies in droves as investors sense the end of the global easing cycle and await the beginning of the US tightening cycle.

On the other side of the ledger we find that the same resources stocks heavily sold down in the first quarter have been heavily bought up again in the third. A level of stability has been found in most commodity prices at much higher levels than analysts had been anticipating some months ago, and in some cases, particularly coal, at surprisingly higher prices. The belief now is the commodity price cycle has turned.

This renewed interest in resource stocks helped the ASX200 to post a 3.8% gain over the September quarter, despite sector rotation, rather than market-wide buying, being the dominant theme. On a twelve month forward basis the index is trading on a PE of 16.2x (as of last week), which in Morgan Stanley’s words “continues the recent trend of elevated multiples in the absence of a meaningful turn in earnings growth”. Both industrials ex-financials and resources are trading at 20x.

High PEs imply strong positive sentiment towards the stock market as an investment choice. In a “normal” trading environment, if there is such a thing, PEs rise on the expectation of earnings growth – prices rise first and then reported earnings catch up. But many an analyst has been forced to acknowledge that in an era of unprecedentedly low global interest rates, historical PE comparisons are not quite apples to apples. Investors are desperately searching for yield and it can be found in the stock market. This implies a TINA premium needs to be applied to the “fair value” market PE – there is no alternative.

Earnings growth, or lack thereof, has nevertheless stabilised, Morgan Stanley points out. For FY16, the ASX200 posted a 12.6% decline in earnings. Forecasts currently suggest 7.4% earnings growth in FY17, 8.0% in FY18 and 8.5% in FY19. Upgraded earnings expectations for the resource sector account for some 25-30% of growth forecasts, Morgan Stanley notes.

The broker is Overweight both the materials and energy sectors, citing the earnings upgrade cycle, macro support, as yet underweight positioning by investors and improving supply-side dynamics. Morgan Stanley’s key Model Portfolio positions include BHP Billiton ((BHP)), Woodside Petroleum ((WPL)) and Oil Search ((OSH)). Broader market exposures include Rio Tinto ((RIO)), South32 ((S32)) and Western Areas ((WSA)).

In January this year, Morgan Stanley strategists set their year-end target for the ASX200 at 4800. They have now upgraded to 5200. The two main reasons are a less bearish stance on Brexit implications and a more positive view on China.

Of course, given the index is trading at around 5480 at the time of writing, this implies fourth quarter weakness.

Morgan Stanley is warning investors against chasing the market rally given risk to domestic growth, as the “muddle-through” Australian economy (25 years uninterrupted growth) and the housing boom face fatigue. With the RBA seemingly on hold for the time being and cracks starting to appear in housing, the broker finds it difficult to see any meaningful index upside while industrial earnings remain soft.

Morgan Stanley is Underweight the banks and is cautious with regard the consumer and housing-related sectors.

Note that Morgan Stanley is one of few brokers convinced the banks will need to undertake a second round of capital raisings in order to satisfy new regulatory requirements. Not all brokers believe this to be inevitable.

Quality and Size

Warren Buffet once said “it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. In other words, it is safer to pay for quality than to gamble on value, as represented by a cheap price.

Quality companies with defensive earnings streams used to be the plodders of any bull market, offering safety and reliability rather than blue sky upside. But since the GFC, economic uncertainty has sent investors into safety and an ageing population has sought a reliable yield, Goldman Sachs notes. In past years investors have “shifted up the quality curve’, paying more for such companies.

By contrast, what used to be considered “value” bets have suffered several years of significant underperformance. Increased technical “disruption” is one reason Goldman cites. What were once must-haves on any price dip have failed to deliver as they have in the past. But it’s not all about the online start-ups and Ubers of the world. Many an Australian investor has stuck stoically by Woolworths ((WOW)) as a value bet on any dip, for example, while ignoring the impact of $1 milk and a German invasion.

The trick, of course, would be to invest in quality at value, but that horse has bolted. Indeed, Warren Buffet would find it difficult to buy value at a “fair” price at present. Goldman Sachs notes, nevertheless, that “quality” has underperformed in 2016. However, this is largely due to certain companies previously perceived as “quality” suffering a series of earnings downgrades, suggesting they perhaps can’t be considered “quality” anymore.

See above example.

Yet true quality remains expensive. The top 40 stocks in Goldman Sachs’ “quality” list are trading at a 40% premium to the market PE, close to all-time high PEs, and 20% above their long-run average. So if investors wish to reduce some of the valuation risk in their portfolios, the broker suggests it may be time to look at “fair companies at wonderful prices”. Just don’t tell Warren.

And they are?

Goldman recommends Lease Lease ((LLC)), Charter Hall Retail ((CQR)), McMillan Shakespeare ((MMS)), Commonwealth Bank ((CBA)), IOOF Holdings ((IFL)) and Fairfax Media ((FXJ)).

Does size matter? Among those “quality” underperformers in 2016 have been members of the “very large cap” ASX Top 20, UBS notes, for example banks, insurers and telcos (and Woolies). Large caps have underperformed the mid and small cap stocks since early 2015. But does this mean they now offer “value”?

On a PE basis yes, relative to mid caps and small caps, but as UBS notes, all of large, mid and small caps are currently trading at premiums to their long-run historical PEs (TINA). The Top 20 does look notionally appealing, UBS suggests, on a combination of high dividend yield, moderate PE and moderate price-to-book value ratio. However earnings went backwards in FY16 and FY17 forecasts suggest only a moderate rebound of around 4%.

Earnings revision trends in insurance companies and consumer staples remain weak, UBS notes. The banks may yet have to issue fresh capital. Only if earnings expectations pick up will the large caps begin to attract interest on valuation appeal.

The “defensive yield” trade may, on the other hand, have become more attractive. Australian bond proxies have fallen on the threat of withdrawal of monetary stimulus by both the Fed and ECB, UBS notes (and an RBA on hold), when global growth appears to be tepid at best. But given tepid growth, UBS believes any further rise in bond yields will be moderate rather than severe.

Which might suggest the sudden exit from bond proxies has been overdone. Yet UBS remains Underweight on these sectors.

The problem is one of a reactionary market. Historically, share prices tend to rise in the face of rising bond yields as typically, rising yields imply an improving economy. However as the 2013 “temper tantrum” in the US demonstrated, when the Fed first suggested it would look at winding back its QE program, a sharp shift in bond yields can have equity investors running screaming for the door.

Were the next move by the Fed to spark a similar shift in an overbought bond market, a similar equity market result may be the result. That’s a risk UBS is not currently willing to take.

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