Hugh Dive, Head of Listed Securities

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Tales from the Trenches - Gazing into the crystal ball

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In forecasting the future, especially the future direction of the equity markets, one prediction is sure to come true: that all predictions will be wrong. In the final Tales of the Trenches for 2014, the Philo Listed Research team provides a view of how we expect the Australian equity markets to perform over the next twelve months. This does not involve peering into a crystal ball or gazing at tea leaves and chicken entrails, but rather is derived by analysing the ASX on a "bottom up" or stock by stock basis. Whilst recognising the limitations of all forecasts, in this week's piece we are going to run through our current view on the returns we expect Australian equity investors to enjoy over the next 12 months.

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Below average returns

At the end of the December 2014, the S&P/ASX 200 is currently at 5283. After conducting a bottom up analysis on Australian equities, Listed Securities are forecasting 7% total return (or weaker than average) for the next 12 months and for the S&P/ASX 200 to finish around 5400.

This forecast is below the long term average return from Australian equities of +9% and is derived from the following inputs:

  1. Expected aggregate earnings growth of 2% based on the below bottom up analysis of the market by analysing the expected profit growth from all the companies in the ASX 100. This is below the 11% consensus growth expected by stockbroking analysts a mere six months ago.
  2. No change to the overall market price to earnings (PE) ratio from the current level of 13.6x. Minimal earnings growth is unlikely to deliver an expansion in the market's earning multiple.
  3. Overall market expected dividend yield of 5.1%. The banks comprise a third of the index and are paying dividends supported by their expected earnings. Whilst the major miners have seen their earnings come under pressure, their low payout ratio, commitment to paying progressively increasing dividends and the spectre of RIO being taken over should see cash returns to shareholders maintained.

Underlying bottom-up outlook

  • Banks: Consensus EPS (earnings per share) growth has increased to 7% post reporting season in October. This seems reasonable in light of subdued credit growth (~5%) across the sector and the full impact of recent cost cutting initiatives. In the most recent results the major banks reported strong profit growth driven by historically low levels of bad debts. Whilst the potential exists for bad and doubtful debts to spike with a slowing domestic economy, this is unlikely to have a major impact over the next year.
  • Metals and Miners: We expect EPS to fall by 15% based on lower average iron ore and oil prices. However a falling AUD, cost cutting and higher volumes from newly completed project expansions will cushion some of the fall for the large miners. Share prices should continue to receive some support from dividend yields, which for BHP and RIO are the highest levels in 20 years. RIO Tinto’s management will be highly motivated to deliver returns to shareholders in 2015, with the acquisitive Glencore circling!
  • Insurance: Overall EPS growth of +9%, though insurance earnings are always challenging to forecast as weather has a significant influence. IAG have made an earnings decretive acquisition which is expected to reduce earnings per share by 10%, but  Suncorp (+9%) are expected to generate solid growth based on continued mild East Coast Australian weather. QBE are expected to generate +20% EPS growth due to operational improvements and cycling off a challenging 2014.
  • Oil & gas: EPS growth flat on declining oil prices being offset by production growth from new facilities (Santos’ GLNG and Oil Search’s PNG LNG).  Ongoing capex concerns for major projects in development is becoming less of a concern for the sector as these projects begin to approach completion: APLNG (Origin) and Gladstone LNG (Santos).
    Industrials: We are forecasting EPS growth of 5%, with strong results expected by those companies benefiting from a range of factors including Brambles (currency) and Transurban (road upgrades).  
    Transport: Earnings growth in this sector has switched over the last two months from -20% to +13% with a 40% decline in the oil price assisting Qantas and Toll.
  • Discretionary Retail: Consensus earnings growth is at +10%, though expectations across the sector are mixed. Whilst Harvey Norman and Tattersalls are expected to generate strong earnings growth, Crown’s earnings are expected to fall due to a declining contribution from Macao. Flight Centre downgraded profit guidance last week revealing weak domestic demand for leisure travel.
  • Consumer Staples:  We see 4% earnings growth from heavy weights Woolworths and Wesfarmers.  This represents slowing of the earnings growth that the grocers have achieved in recent years and is due to increasing competition.  Metcash and Coca-Cola are expected to deliver no earnings growth due to loss of market share.
  • Media:  Sector earnings growth of 5% from a recovery in the domestic media companies Fairfax, Seven West, News Corporation and Nine Entertainment.
  • Healthcare: Consensus EPS growth expected around 15% across the sector as companies like CSL, Sonic and Ramsay benefit from the tailwinds of currency, reduced regulatory interference  and a strong operational environment. Additionally Cochlear and Resmed have released new medical devices that should boost earnings.
  • Utilities: EPS growth across the sector is expected to be +3%, though some uncertainty exists with a number of utilities such as Spark and Duet facing price negotiations with their regulators over the 12 months.
  • Telcos:  We expect EPS growth to be +3%. Slowing fixed line declines and margin growth in mobiles should help Telstra; however competition is clearly increasing from TPG and iiNet.

Conclusion

The next 12 months looks to deliver a below average return for Australian equities after two consecutive strong years (2012 and 2013) of 20% returns for investors and 2014 which has delivered an anaemic return of only 4% including dividends! Given the relative spreads between TD and dividend yields; equities (in particular the banks and possibly the large miners) should find support from investors during market sell offs. We note that the major trading banks currently trade on a grossed up yield of 8.6% vs. 1 year TDs which have fallen over 2014 to 3.3%, which is close to a zero real rate of return after taking out inflation.

Disclaimer

This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment.

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Hugh Dive, Head of Listed Securities


Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.


Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.

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