Local equities still in the race

For a number of years now, the returns offered by the Australian domestic equities market seem to have been in a holding pattern, maintaining strong levels despite predictions to the contrary.

However, while current valuations appear to be beyond fair value, John Murray, managing director of Perennial Value, is quick to add that the market is certainly not yet stretched.

“Over the last year in particular, price-earnings ratios (P/E) have moved beyond what we would term a fair value,” said Murray. “However, in making that statement, Perennial is guided by comparisons with long-term averages, so we would also say that the market is not yet at full stretch.”

Murray said the key driver behind the domestic equities market’s current position was corporate profits.

“We are in the middle of company reporting season at the moment and profitability is looking sound,” he said. “Corporate Australia is simply in very good shape. We have seen 10 to 15 years of great growth.”

Yet, after a number of years in which domestic equities returns seem to have defied gravity, not everyone is sure of current market value.

Mark Delaney, chief investment officer of the newly formed AustralianSuper, said valuations on the domestic market are hard to get a read on at the current time.

“Looking at sectors in isolation, industrial stocks are at the upper end historically, while resources are at the lower end, reflecting their previous strength,” he said. “Overall, the market is where it’s been for the last 10 years and given that, it is unlikely that valuations are going to give a good indication of what is going to happen in the next two years.”

Tim Ridley, senior consultant at Frontier Investment Consulting, assesses Australian equities in the context of how they compare with their international counterparts.

“We are in a situation very similar to six months ago, where Australian equities still look expensive when compared to international,” he said.

Interestingly, Ridley said that though he saw domestic equities as quite expensive in relative terms, he noted that some fund managers believe the market is close to fair value, as the market PE is close to its historic average.

“Favourable fundamentals have underpinned the Australian equities market over recent years,” he said. “In particular, earnings growth has been strong and inflation, while currently an important risk, has so far been benign.”

For Delaney, there are two key factors behind the prolonged strong performance of domestic equities.

“Firstly, there has been a massive surge in earnings,” he said. “This has been centred on resources, but it has been on a broad basis as well. Essentially, earnings have matched stock prices and their increases, and it is this earnings growth that has been the most difficult thing for people to get a handle on.

“The second factor is that there has been a lot of private equity activity in the market,” added Delaney. “The result has been that many of the stocks with potential for growth and returns have been pushed up in value along with those that are perhaps more tried and tested. Time will tell if that potential is realised.”

Delaney said the real mover in the market over the last four years has been earnings, and it is here that his focus would lie, and not valuations.

So while a clear picture of the future of the domestic market continues to be elusive, there is little argument that earnings have been the backbone of the market for some time now.

“What we have at the moment is cyclical elevated earnings when measured against long-term trends, which have been underpinned by a significant increase in profit margins, particularly in the resources sector,” said Ridley.

“Within the market, there is a significant difference between valuations in the resources and industrial sectors. On the basis of expected earnings over the next 12 months, diversified resources currently appear cheap, while industrials are looking expensive.”

If the domestic equities market has encountered a stumbling block in the past six to 12 months, it would undoubtedly be fluctuating commodity prices. However, according to Murray, that volatility has helped to caution many investors, fund and private alike. “Twenty years ago, resources were a major component of Australian equities before dropping off,” said Murray. “But they are now a large part of the market again and though there has been higher than historical volatility in commodity prices, the low points that we have seen have been reflective of prudence on the part of investors.

“There are two ways of looking at it,” he said. “There has been a re-rating of the larger stocks in BHP and Rio over the last 10 months. And the question is, are they fair value now? Furthermore, the price languish that we have seen would seem to reflect people thinking that high prices may not be sustainable.

“But, on the other hand, Rio and BHP are still in fantastic shape,” said Murray. “And this is the counterpoint. They are net debt free and in a position where they can withstand a downturn.”

Reflecting the sneaking suspicion fund and investment managers have that the domestic equities market will turn at some point, many funds have been adjusting their allocations over the last six months. And though specific allocations to bonds, listed property trusts (LPTs) and private equity have all been re-examined, the sector of prime interest remains the international equities market.

Within AustralianSuper, Delaney said there had been a gradual shift towards global equities throughout this financial year.

“Some industrial stocks globally have cheaper valuations than you see here in Australia,” he said. “But there is unlikely to be a massive flow of money in either direction. Australian equities are still outperforming international.”

Ridley said Frontier Investment Consulting does not look at the Asian market in isolation, but rather as part of a broad ‘emerging markets’ category, and he suggested that emerging markets were becoming increasingly important.

“Emerging markets are important, but valuations have moved from being cheap to being expensive relative to developed market equities,” he said. However, over the longer term, emerging markets still appear quite favourable.”

Ridley said much of the recent success of emerging markets could be put down to improvement in macroeconomic policies, improved corporate governance, strong links to the fast-growing Chinese economy and a general lowering of debt levels.

In terms of investment abroad, Murray said he could definitely see the logic in funds increasing international equities exposure with a longer-term view.

“In particular, the European markets are looking like good value at the moment compared to Australia,” he said. “And the currency rise that we have seen in recent years makes conditions for global investment far more favourable.”

However, like Ridley and Delaney, Murray believes investors will always tend to have greater exposure to the domestic market.

“It’s simply a case of knowing the people in your street much better than those on the other side of the city,” he said. “Funds are looking at offshore stocks because diversification overseas over time makes a lot of sense. There is exposure to other industries and currencies on offer. But the key, as always, is valuations.”

There seems little doubt that most funds have already or are now looking to alter allocations towards the international market, albeit gradually. And the rewards in doing so seem to be out there, with Dr Shane Oliver, chief economist for AMP Capital Investors, tipping the Asian equity market, excluding Japan, to be the star performer of 2007.

With respect to emerging markets however, Delaney said AustralianSuper was remaining cautious.

“There is no doubt the Asian countries as a whole and India and China in particular will be a substantial part of the world economy in the next 10 years, so their equities markets are likely to perform well,” he said. “But AustralianSuper views this in a medium-term context. It is an attractive area. All emerging markets have had very strong performance over the last four years, but we are very conscious of the need to be careful with the timing of entry into these markets.”

While global equities appear to offer more attractive returns over the medium term, Ridley also said that he didn’t see the listed equities exposure levels of super funds moving quickly towards global equities.

“For most people, international equities are more attractive, but few are making large changes,” he said. “There is a large home country bias, and the tax advantages of investing domestically remain very important.”

Ridley said he expected funds would continue to look abroad for favourable opportunities. “There has been a focus on Asia, largely due to China,” he said. “The China market has performed well, so there are strong investment links throughout the region.”

But with doubt remaining about the longevity of strong Australian equities returns and the temptations to be found within emerging markets and global equities as a whole, how do funds and investment managers ensure they do not chase markets or fall into the trap of knee-jerk reactions?

Ridley recommends following long-term strategies and not to over-emphasise considerations such as valuations.

“On the basis of relative valuations, international equities are looking better than Australian equities. But the reality is you could have said the same thing last year. While valuations are key indicators of medium-term performance, opportunities based on valuations can take a long time to be realised.”

Delaney also stated that the best approach was having a clear process and sticking to that process.

“Some economic and investment environments will suit some processes better than others,” he said. “But changing your process according to market fluctuations is a recipe for disaster.”

Moving forward, Delaney said nothing materially had changed in the domestic equities environment since June of 2006, save for the fact that share markets were higher and earnings stronger.

“Australian equities have certainly been on a good run in the last six months, and this is a run that is unlikely to be repeated,” he said. “But overall, it does look like that run should continue through 2007.”