Weekly Reports | Apr 02 2013
–Cyclicals returning to favour
-Beware the second half, margin risks
-Asia needs an earnings recovery
-Shift to longs in US interest rates
By Eva Brocklehurst
Recent official rate cuts in Australia are still working their way through the economy and should underpin company earnings in FY14. That's the opinion of analysts at Deutsche Bank. Cyclical industrial stocks should benefit from current conditions and the valuations are attractive. Deutsche Bank notes the earnings revision ratio for cyclicals is now around neutral, after several years of heavy downgrades, and this should ensure superior growth vis-a-vis defensive stocks. The broker is also comfortable with US-exposed cyclical stocks. Transport companies should benefit from re-stocking while a recovery in housing should support related stocks. The soft sector is retail, and given spending has not been substantially weak the broker does not see scope for a large bounce there. Therefore, good price/earnings growth rates are envisaged for cyclical industrials, with the exception of retail and mining services.
In light of this Deutsche Bank likes Toll Holdings ((TOL)), Asciano ((AIO)), Boral ((BLD)), Stockland ((SGP)), BlueScope ((BSL)), Brambles ((BXB)), News Corp ((NWS)), Aristocrat Leisure ((ALL)), Westfield ((WDC)) and Crown ((CWN)).
Some caution is still required. BA-Merrill Lynch also suggests the risk of sizeable earnings downgrades is now low, but there are individual exceptions. With valuations nudging multi-year highs, there could be a disproportionate fall in share prices if the risks eventuate, the broker warns. In summary, there are two stock-specific risks the broker encounters. The first is relying too much on the second half, particularly if there are unusual expectations of a higher proportion of sales in the period. Stocks cited for a watch in this regard include Computershare ((CPU)), Harvey Norman ((HVN)), UGL ((UGL)), Ansell ((ANN)) and Sims Metal ((SGM)).
The second risk is margin. Some stocks received a reprieve in the latest reporting season but Merrills is cautious about extending the expectation of margin improvement too far. This is the case for domestic sectors where structural headwinds are intense and demand is soft. The broker finds consensus margin forecasts appear optimistic for Harvey Norman, Metcash ((MTS)), Echo Entertainment ((EGP)) and Toll.
Working capital deterioration could also suggest more deep-seated problems, according to Merrills. The broker notes Ansell's inventory is turning over at the slowest rate for some time. Among consumer stocks, Coca-Cola Amatil ((CCL)) and Super Retail ((SUL)) have enjoyed an improvement in cash conversion which should still drive shareholder value. The broker accepts that holding quality stocks has been detrimental to portfolio performance over the past six months. Nevertheless, low-quality stocks that do not cover the cost of capital are now viewed as expensive.
Taking into account earnings risk and valuations, Merrills is most wary of domestic cyclicals such as David Jones ((DJS)), Harvey Norman, Toll and Tabcorp ((TAH)) and some industrials such as Ansell, BlueScope and Sims Metal. The broker's advice is leaning towards inexpensive resource stocks such as Newcrest ((NCM)) and Iluka ((ILU)) and quality stocks where earnings growth appears less risky such as News Corp and Brambles.
Merrills' Asia-Pacific strategy is positive. The broker notes the improved performance in Asian equities over the last 12 months has been mainly driven by a re-rating of stock, rather than earnings upgrades. Merrills believes Asia needs an earnings recovery to justify a continuation of the stock rally and this could be at hand. The strategists recommend positioning for an economic upturn and favour China and India, and financial and motor vehicle stocks. Out of favour at this stage are expensive defensive stocks such as Hong Kong utilities and late-cycle sectors such as materials.
On Australia specifically, Merrills finds the market has pushed up quality defensive stocks with reliable earnings. Now these appear expensive. The strategists think the time is right to rotate away from these sectors. Merrills is underweight energy, which has been underperforming over the last two years, and neutral on materials, which is also underperforming coinciding with weak iron ore prices. The broker is comfortable with expectations of flat earnings overall for FY13 and growth around 12% in FY14. This judgement is derived from the broker's earnings model, which gives some sight on earnings growth over the next 12 months. The model uses global purchasing manager and consumer sentiment indexes as input, and currently suggests bottom-up forecasts are reasonable. A final word from Merrills: equity markets usually perform well in the first half of the calendar year, underperform in the third quarter, and finish the year strongly.
Further to the macro view, Citi's GRAMI (Global Risk Aversion Macro Index) is back in positive territory this week, despite the Cyprus debacle. Nonetheless, investors are not overly confident. Citi's NISI (News Implied Sentiment Indicator), which aims to capture investor sentiment via news stories containing the keywords bullish and bearish, deteriorated slightly last week and remains in bearish territory. Citi has also monitored fund flows and rotation is not yet a theme. Flows are going into both equities and bonds. From foreign exchange position indicators Citi has observed net long positions in US dollars versus other G10 currencies and also on a global basis. Euro positioning is short and British pound short positions have been extended, while Japanese yen positioning is back to neutral.
On US interest rates Citi's monthly measure reveals a sharp shift to net long positions in March, outnumbering short positions by 32%. This is the largest net long bias in three years. The analysts do emphasise that 40% of investors remain neutral. Citi's global credit survey shows a correction in leveraged positioning to neutral from long, while real money inflows are at their lowest since 2008. After unwinding sharply recently, Citi's measure of commodity appetite shows non-commercial net long positions on the rebound last week. Citi’s latest US survey reveals cash balances have increased and 84% of respondents are looking to allocate capital to equities.
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