Last year was indeed a tough one for Australian equities. The S&P/ASX 200 Index got off to a flying start and there was plenty of optimism that 2010 could be another strong year for the market. Then from April, the rally started to fizzle as investors began selling down many of their holdings over fears that Portugal, Ireland, Greece and Spain may default and cause a double-dip recession. The flagship Australian benchmark ended the year with an unremarkable 1.6% gain. And it could have been much worse if not for the resources sector's 10% rally on the back of strong demand for raw materials from major emerging markets, including China and India.
While the bailout of Greece and Ireland may have somewhat calmed investors' nerves and given them more confidence about coming back and snapping up equities in 2011, market experts are urging financial planners to tread lightly with where they invest clients' money.
Big worries still linger over whether the European bailout fund will be large enough to save Portugal, Spain, Italy and Belgium from default should those nations also require emergency cash. Ongoing concerns remain over the health of the United States and Japan, with both major economies continuing to rack up enormous debt and growing too slowly.
And to add to those largely overseas issues that nonetheless affect investor sentiment towards Australia, the local market faces its own set of unique challenges, including a two-speed economy, a new resources tax and a fresh levy arising from the Queensland floods. There is also a structural shift in consumer behaviour that's hurting retailers and uncertainty over how local banks will navigate through the new Basel III global bank rules.
Still, despite this backdrop of headaches and taxes, some of the financial services industry's top fund managers believe the Australian market has priced in much of the uncertainty and 2011 could be a good year for investors, provided they pick the right sectors and stocks.
Reasons for Optimism
Merrill Lynch Australia strategist Tim Rocks says 2011 is shaping up to be a strong year, with the firm having a target of 5,500 points for the S&P/ASX 200. "We think valuations are reasonable now. The forward price/earnings ratio for the Aussie market is just a little bit over 12. At the start of 2010 it was 15 and the long-term average is about 14," Rocks says.
"We were also concerned that earnings forecasts were too high and needed to be cut; that has basically happened. You have had a 10% downgrade in earnings since the middle of 2010 and that has taken earnings back to much more normal levels." Rocks also says the European debt concerns are abating, as is the risk of a double-dip recession in the US.
Greencape Capital portfolio manager David Pace agrees double-digit gains are possible. Pace says that relative to its 10-year average, the Australian market looks about 15% cheap currently. "So what I would say is to the extent that macroeconomic conditions don't deteriorate globally and further exogenous shocks don't occur, I think a 10%-15% gain looks achievable for the S&P/ASX 200," he says.
"On the economic front we think global economic indicators will be supportive of market returns, particularly in the first part of the year by what is quite accommodative US monetary policy and continuation of tax cuts in the US as well.
"But I have got to say medium to long term we still remain reasonably cautious in part because of the growing US fiscal debt levels and what I like to call the apparent kicking of the 'economic turmoil can' down the road."
Fidelity Investments' head of Australian equities Paul Taylor says he's quite positive on the prospects for Australian equities over the year ahead. "The long-term positive fundamentals of the Australian market remain in place and valuation levels are currently very attractive," Taylor says.
"Also, Australia's strong fundamentals of high population growth, excellent and low-cost natural resource base, good corporate governance and a high dividend yield and high real dividend growth are still very much in place as we move into 2011.
"Australia, and the market, will also benefit from the high economic growth from emerging markets and the resultant positive impact on demand for resources and commodity prices." Taylor adds that there are currently many opportunities to buy great quality companies at attractive prices. "Combining this strong growth outlook with the attractive valuation levels could well mean a strong Australian equity market performance in 2011."
Resources, Tax and Rio Tinto
The resources sector has faced much uncertainty in recent times. The Australian government sparked immense controversy after it first announced in May 2010 that it would push for a 40% resource super profits tax (RSPT) on mining profits.
However, after a severe backlash from the mining industry and investors, the government a month later stepped back and watered down its proposal to the mineral resource rent tax (MRRT), which was well received by the likes of BHP Billiton (BLT), Rio Tinto (RIO) and Xstrata (XTA). Unlike the RSPT, the MRRT will only apply to the mining of iron ore and coal, with the levy reduced to 30%.
BT Investment Management portfolio manager Jim Taylor says the impact of the MRRT, which hasn't passed through parliament yet, will only be modest. "We're talking in the order of single-digit percentage impacts on the net asset value of those companies based on the most recent version that we have seen," Taylor says.
"Overall we think the actual impact on those larger companies is actually quite modest and even when you look at the cost of production for those companies versus current selling prices for iron ore, the cost of production is around US$30-50 a tonne versus current selling prices of north of US$150 a tonne.
"These companies are making a tremendous amount of money from these commodities. At the moment we are right in the sweet spot so you would expect that they would pay a significant amount of tax during that period, but based on longer-term average prices the companies would assume obviously the amount of tax they pay would be much more modest."
He says one of his preferred picks in the sector is Rio Tinto as the company is attractively valued. "We quite like the outlook for iron ore and coal at the moment and even the prospects for aluminium seem to be improving," he says.
Taylor adds that Rio is generating enormous amounts of free cash flow as it is selling its iron ore for US$150 a tonne, with a production cost around US$30-40 a tonne. We would expect the company to announce capital management programmes and institute buybacks to absorb some of that excess cash flow and on all our measures the stock looks to represent very good value around here," he says.
Rio is also one of Above The Index Asset Management's (ATIAM) most relatively attractive companies. "Our work shows us that based on the commodity price expectations out there it still looks cheap. It also looks cheap relative to other choices in the market," ATIAM chief investment officer Simon Burge says. "There are also other positives for Rio; for instance, it has been raining heavily in South America and so its major competitor, Vale, has not been getting as much iron ore out.
"The other thing is that India in recent days has talked about potentially stopping exports of iron ore because they are big users of the commodity themselves," Burge adds.
SG Hiscock & Company portfolio manager Robert Hook agrees Rio is very attractive, even more so than its larger rival BHP Billiton. "We prefer Rio Tinto over BHP at the moment as we think the strength in the iron ore prices will continue and this is the major source of their income," Hook says.
"Iron ore is one of Rio's big strengths, but in addition it has copper, coal and aluminium, all of which are doing well at the moment.
"BHP has a more balanced mix of copper, oil and iron ore but the ramp up in iron ore production has been slower and the failure of the Potash (POT) takeover was a negative. We also prefer Rio's relative valuation to BHP's."
Hook also likes Oil Search (OSH). "To get our exposure to oil we have taken a position in Oil Search. That company's announced that two trains now will go ahead and supply gas and it's in the process of getting a potential third train on the way," he says.
While the managers have noted that bulk commodities is one of their key themes, Merrill Lynch Australia's Rocks argues energy could deliver superior rewards. "We are much more comfortable taking exposure to energy stocks as opposed to stocks with predominantly bulk commodities," he says. "If you look at the energy intensity you can see China's energy intensity is very, very low by the standards of the developed world, so it has much more further to go.
"We think that steel intensity is not as strong. Even BHP are expecting growth of 2%-5% over the next 10-20 years in steel intensity and we think the upside to energy is much, much higher."
