Australian equities outlook

The Australian equities market delivered another strong performance in the 2006 calendar year, with the S&P/ASX 200 Accumulation Index ending the year 24.2 per cent higher.

Strong offshore growth, particularly in the Asian region, was again an important driver, as exceptional gross domestic product growth in China and India continued to capture the imagination of investors.

Resource stocks led the way again in 2006, as exceptional commodity price gains continued to fuel resource company earnings. The commodity price gains of 2006, particularly in supply-constrained commodities such as zinc and nickel, were far greater than those of the prior year, as solid underlying demand was accompanied by significant inflows from investment funds. Whilst the identification of ‘bubble’ characteristics will remain far easier in retrospect than in prospect, the 2006 year has ended with some very significant levels of market capitalisation in a number of commodity businesses without commensurate profitability.

Additionally, in many of the more established companies, the comfort provided to investors by low price-earnings multiples at a time where commodity prices are in many cases at multiples of longer-term prices may, in our view, prove illusory. Nonetheless, gains for investors in the sector have been outstanding, with total returns for the 2006 calendar year in stocks such as Zinifex (+185 per cent), Minara Resources (+218 per cent) and Paladin Resources (+351 per cent) amongst the more exceptional gains in larger stocks.

Whilst corporate activity remained strong throughout the year, the emergence of private equity as potential buyers of some of the country’s largest companies was probably amongst the more unexpected developments of the year. Suggestions that household names such as Coles Myer and Qantas would become the subject of private equity interest would undoubtedly have surprised even seasoned market participants at the outset of 2006. Some of the more significant corporate deals of 2006 have included the bid for Rinker by Cemex, finalisation of the takeover of Patrick by Toll, and the still unresolved bid for Promina by Suncorp Metway. Numerous smaller company transactions have been undertaken, whilst the Australian listed property trust (LPT) sector has continued its apparent drive for world domination through an extensive list of (primarily) foreign asset and business purchases.

The listed property sector has undoubtedly been one of the more surprising performers in the market, as a comparatively mundane earnings outlook and a relatively stable bond market would not have been expected to provide the catalyst for the significant share price gains in stocks such as Macquarie Goodman (+65 per cent), Centro Group (+42 per cent) and GPT (+43 per cent).

Outlook

Whilst we continue to find opportunities to purchase stocks with attractive franchises at reasonable prices, we are equally adamant that pockets of significant excess in the current market will subdue future returns in certain sectors. The devotion of capital to sectors and assets offering speculative capital gain rather than the prospect of longer-term value creation underlies the boom-bust nature of most cycles, and we remain sceptical of any ‘new paradigm’ theories that forecast an end to traditional cycles. Whilst economists and strategists broadly remain of the view that interest rates, growth and markets will remain benign, it appears to us that this stems more from extrapolation than unusual insight. In the words of George Bernard Shaw: “If all economists were laid end to end, they would not reach a conclusion.”

Portfolio review

The Schroder Wholesale Australian Equities Fund portfolio returned 25.1 per cent (pre fee) for the year, compared with the benchmark performance of 24.2 per cent, an outperformance of 0.9 per cent.

As cynics with relatively subdued expectations, we are more than pleased with the returns delivered by the stock market in the past year. Given the cautious position in resources at the year’s outset and an even more cautious position in real estate, we are equally pleased to have delivered a result above the overall market for the year. Having acknowledged that our sector bets were not positioned for short-term gain, the fund’s performance was obviously driven by strong stock selection.

Positions in Dyno Nobel, Patrick Corporation (and, subsequently, Toll Holdings), Promina, Brambles, Woolworths, Computershare and CSL were all strong contributors to performance. Importantly, many of these holdings have been very long-term holdings in the fund, as we are firm believers in the quality of the franchises and continued growth prospects. We are most comfortable when we see companies such as these assist investors’ long-term performance by slightly outperforming the average stock every year, rather than having portfolio performance driven by exceptional gains in a small number of speculative stocks. On objective measures such as return on capital and economic value creation, all of these businesses have, and continue to deliver, strong performance. All are still held in the portfolio.

The list of detractors from performance primarily includes stocks that we failed to own, rather than stocks that we did own that went down. Many of these were in the areas of resources and real estate. We cannot claim to have forecast the more than doubling of the zinc price over the year, nor the coincident gain of 185 per cent in Zinifex, a relatively high cost zinc producer. Similarly, despite significant research efforts and experience in the market, we did not anticipate the sharp rise in stocks such as Centro Group and Macquarie Goodman at rates far exceeding their earnings growth and value creation.

Newer positions in the portfolio include Suncorp Metway, Boral and Telstra, while new holdings in smaller stocks include GRD, Healthscope and Ramsay Healthcare.

Telstra remains a controversial holding, and whilst likely to remain the subject of fierce criticism from much of the media and stockbroking community, our rationale for holding the stock is straightforward. We believe the likelihood of Telstra losing its dominant position in the telecommunications industry is low, as scale advantages will remain crucial in a capital-intensive business. Risks to the stock, therefore, centre on ongoing deterioration in industry revenues. We believe the Telstra valuation already reflects significant caution on future earnings and, in comparison to other popular defensive stocks, is significantly underpriced.

2007 Outlook

Our views on the market stem almost solely from our views on the earnings prospects of the businesses in the portfolio and the price that we are paying for these earnings. Whilst we assess the valuations of these businesses versus the returns available in other asset classes, we do not believe our insights on the direction of interest rates and other macroeconomic variables offer us any material advantage.

The prevailing theme on the earnings outlook for stocks held in the portfolio is one of caution. We confess to not sharing the enthusiasm of many broking analysts on the prospects of continuing strong growth in revenues and margins across a number of sectors that have already enjoyed an extended period of buoyant activity.

In major sectors such as banking, resources and real estate, the gains in recent years (for disparate reasons) have been exceptional.

In the case of banks, very strong credit growth has coincided with benign experience on bad debts.

In resources, the impact on Australia and mining stocks of soaring commodity prices driven by booming Chinese demand is obvious to even the most infrequent newspaper reader, whilst real estate stocks have enjoyed a number of years of share price gains well beyond growth in underlying cash flows. The heavy reliance of the overall market index on these sectors (well above 50 per cent) makes us cautious on future returns. Unsurprisingly, in seeking future returns, our stock holdings are disproportionately outside these sectors.

We continue to find attractive longer term opportunities in the market, as extremely favourable conditions in certain sectors will invariably cause investors to disregard opportunities in businesses which may have far more attractive characteristics but less exciting short-term operating conditions. We would not expect returns over the coming years to be anything like the exceptional levels of recent years, as the fear versus greed barometer is firmly tilted to the latter, however, we still find no shortage of stocks offering solid long-term return prospects.

Martin Conlon is Schroders head of Australian Equities.