Broker Strategies For Equities As Rates Fall

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-Important to examine actual returns
-Likely rotation into domestic equities
-Yield and growth theme can continue
 

By Eva Brocklehurst

Headwinds abound in both the global and domestic environment for equity investors, brokers contend, and various strategies need to be engaged to pick through the opportunities that may present.

Goldman Sachs believes it important to not let poor allocators of capital get away with it. The broker notes since the Global Financial Crisis (GFC) write downs of fixed assets and goodwill have accounted for over 70% of the one-off charges for ASX 200 stocks, with 70% of those coming from resources. Depressed returns suggest there are more to come.

On the issues of earnings quality it seems to Goldman Sachs that, while many firms have sought to downsize or restructure to improve efficiencies in a soft revenue environment, some are taking these costs as a recurring operating expense while others are reporting them as one-offs.

The broker acknowledges that some large one-off charges skew the statistics but there are some stocks that report large unusual expenses at least every second year, and investors typically pay little attention to non-cash write offs unless it prevents a dividend payment or debt covenants are likely to be breached.

At the top of the repeat offenders list are CSR ((CSR)), Treasury Wine ((TWE)), Independence Group ((IGO)), Origin Energy ((ORG)), Pacific Brands ((PBG)), Nufarm ((NUF)), GWA Group ((GWA)), APN News & Media ((APN)), Seven West Media ((SWM)), Newcrest Mining ((NCM)), Santos ((STO)) and Aristocrat Leisure ((ALL)).

Goldman Sachs believes the free kick to earnings growth and returns on invested capital (ROIC) given by write offs is often overlooked and it is important to critically examine the returns a business is actually generating on the capital invested.

Of the 28 industrial firms under the broker's coverage that are forecast to improve ROIC by over 1.0% by FY18, less than half are expected to improve cash returns. Stocks where the signalled lift in cash returns is largest include Blackmores ((BKL)), Sirtex Medical ((SRX)), Premier Investments ((PMV)), Treasury Wine, Cochlear ((COH)), Domino's Pizza ((DMP)) and Cimic ((CIM)).

RBA Rate Cuts

The Reserve Bank of Australia recently trimmed the cash rate to a new low of 1.75%. UBS expects another 25 basis point reduction in August to 1.50%, with risk of further easing. The broker notes rate cuts tend to provide a short-term temporary boost to the Australian market and depress Commonwealth 10-year bond yields and the Australian dollar.

Rate cuts boost bank sector performances over the medium to longer term. Meanwhile, the discretionary retail sector underperforms in the short term but outperforms in the longer term.

The broker believes this move by the RBA is a net positive for interest rate sensitive sectors and foreign currency earnings but external factors, such as the US Federal Reserve's own trajectory on rates, and the sustainability of the recent pick up in Chinese commodity demand are likely to dominate going forward.

Enhanced Dividend Appeal

Deutsche Bank makes the observation that, despite the RBA resuming an easing cycle, the negative rates in the EU and Japan and stalling rate hikes from the US Fed mean the dividend appeal of Australian equities is enhanced. The broker suspects local investors may rotate into domestic equities, as super funds are currently overweight in deposits, even with their minimal real return.

The question is whether these dividends are sustainable. The broker has some concern at first glance but believes this is largely a resources story, finding low dispersion in yields but also in pay-out ratios among Australian equities. While acknowledging concerns that high pay-out ratios could crimp capex and thus future growth, Deutsche Bank counters that non-resource companies can still obtain cheap debt funding given their below-average gearing.

The broker does not believe Australian bond yields have a lot of downside to go, having come down 300 basis points in the past five years, but may overshoot a little more in the near term. Of the traditional yield players Deutsche Bank prefers Sydney Airport ((SYD)), APA Group ((APA)) and Suncorp ((SUN)).

Banks are finding a floor, the broker suspects, and offer a stand-out yield while foreign investors are underweight in Australian banking. Deutsche Bank suggests that households, earning minimal returns on deposits, could opt for a better return by turning that bank deposit into a bank share.

Moreover, investors need not confine themselves to traditional low-growth dividend names, with the broker suggesting a range of stocks with yield plus growth. Key stocks in this category are CSR, Harvey Norman ((HVN)), Stockland ((SGP)) and Pact Group ((PGH)).

Macro Headwinds Looming

Morgans believes the numerous macro headwinds will test investor nerves in the next couple of months but there should be opportunities if investors are prepared to be tactical. Of the macro events shaping up to be turbulent, the broker includes the possibility of Britain leaving the EU with the vote next month.

That said, the risks are overplayed, in the broker's opinion, but the possibility exists to add companies with a strong UK/sterling exposure such as Clydesdale ((CYB)), BT Investment Management ((BTT)), Macquarie Group ((MQG)), QBE Insurance ((QBE)) and PWR Holdings ((PWH)).

Weaker AUD And Beneficiaries

In terms of the Australian federal election on July 2 the broker's analysis suggests the market is more likely to rally into and out of the actual election and markets tend to look through the political uncertainty. Domestic data is likely to be more crucial to arresting concerns about the economy and the slide in the trade weighted value of the currency. Morgans expects the Australian dollar to continue to slide towards US70.5c by year end.

Those stocks which should benefit from the lower Australian dollar include defensive names such as ResMed ((RMD)) and CSL ((CSL)). Morgans believes the market is losing sight of the improvement in the US economy but those stocks with defensive yield and earnings certainty should position investors for any volatility. The broker likes Aventus Retail ((AVN)), 360 Capital Industrial ((TIX)), Westpac ((WBC)) and Sydney Airport.

Morgans also believes there is still room in the rest of the financial year for companies to review earnings expectations and there is some risk that they will continue to lower guidance for FY16. This is likely to be particularly pronounced in the cyclical sectors, as consumers and business hold off spending until after the election.

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