Australian Equities
China’s economic takeoff has been fantastic for Australia. The jump in our terms of trade since the early 2000s boosted the earnings of materials, energy and mining-services (industrial) stocks. This in turn sparked an investment boom here, enriched shareholders and flooded government coffers, which helped create a thriving economy that benefited domestically focused companies. And didn’t our stock market respond. The S&P/ASX 200 Accumulation Index soared 139% in the 10 years to 31 December 2012, more than double the 62% gain in the S&P 500 Index over that time.
But the endless years of China’s 10%-plus GDP growth appear gone. Our biggest trading partner confronts a financial crisis that is expected to lower economic growth to about 7%, at best, in coming years. Some analysts expect China’s annual economic growth to slow to as little as 4%, while the most pessimistic reckon that China is already in a deflation spiral.
Given the bleaker outlook for China, investors can be forgiven for thinking that Australian equities will underperform in the years ahead as mining shrinks from its peak of about 8% of GDP towards its long-run average of about 2%. It’s true that doubts about China-driven material stocks have overshadowed the ASX in the past six months. The S&P/ASX 200 Materials Index fell more than 26% from mid-February to late June, before recovering somewhat. Another sign of the harder times for miners is that when S&P Dow Jones in September rebalanced the indices on the ASX most of the stocks dropping down were materials-related companies. Three of the five stocks banished from the S&P/ASX 200 and 23 of the 25 ditched from the S&PS&P/ASX 300 were mining-dependent companies.
But the doubts about China have not hammered the relative performance of the S&P/ASX 200 Accumulation Index overall this year. It’s risen almost at the same pace of the S&P 500 since December 31 (17.9% versus 16.2% to September 30), having only noticeably underperformed the US benchmark for those few months after April when news from China was bleaker. This is a sign of the ASX’s resilience to China’s woes. Investors in Australian equities can take heart that even amid misgivings about China there are several forces acting for Australian equities that may well see them generate decent returns in coming years, especially against alternative asset classes. Some of these reasons are not that obvious.
The first, and one that is often highlighted, is that any China-induced slowing in Australia’s economic growth will be partially self-stabilising. The China-inspired boom in mining led to higher interest rates, which inhibited the rest of the economy, and bolstered the Australian dollar to record post-float heights, which eroded the competitiveness of non-mining sectors and the local value of foreign-source earnings. The opposite reaction is now occurring to some degree. The RBA has already cut the cash rate to a record low of 2.5%, having reduced the rate from its post-crisis peak of 4.75% since October 2011. Our dollar has dropped from its post-1983 high of US$110.20 in July 2011 to around 93 US cents in early October. These are not perfect antidotes to export income lost and taxes forgone but they will help non-mining sectors expand in coming years.
The second reason is that Australian equities present a decent tax-effective dividend yield while offering the possibility of some growth – a perennial argument in favour of Australian stocks. The ASX is home to a host of cash cows that earn bumper returns from operating in less-than-fully competitive markets, such as the bank oligopoly and the supermarket duopoly. These stocks duly return a high portion of their earnings to shareholders, generally as dividends. The S&P/ASX 200 Index on October 1 offered a dividend yield of 4.25%. This was above the 3.8% yield on 10-year government bonds that day and exceeds the rate on term deposits, which are less attractive options when the cash rate is at historic lows. While shares can always suffer capital losses, bond investors confront this proposition too when interest rates are so low and threaten to rise.
The third reason, and another oldie but goodie, is that Australia’s franking credit system has forced Australian companies to be better managers of capital since it was introduced in 1987. Managements are under pressure to deliver tax-effective returns for shareholders rather than just grow (although retailers tend to prefer store rollouts rather than higher returns on equity). Our banks, for instance, have achieved the highest long-term cash flow return on equity since 1988 when compared against European (ex-UK) and US peers. Australian banks have a return on earnings on this basis of 11.7% over that time compared with 8.4% for European and 9.6% for US competitors, according to Credit-Suisse HOLT. Telstra and Woolworths do just as well against their foreign foes. The financial discipline behind this result, which it must be said is partially due to diluted competition Australian companies enjoy, underpins the reliability of long-term returns on Australia’s stock market.
Travelling well
The fourth reason Australian equities are expected to offer decent returns in coming years – and the first of perhaps the less obvious reasons – is that while commodity prices have dropped in recent times (though not iron ore) volumes of minerals sold are rising. Despite a 7.3% drop in the RBA’s commodity price index in the year to August, analysts still forecast minerals sales by volume to rise enough to prop up revenue this year. Since Australian miners are among the world’s lowest-cost producers, we can expect the sales and profits of the largest miners such as BHP Billiton and Rio Tinto to hold up. So too should their share prices since their managements are focused on controlling costs to ensure healthy returns on equity. Analysts predict the earnings per share of mining stocks to rebound towards record highs over the next three years.
Another more-obscure reason for having faith in Australian shares is that our companies are more adept at expanding overseas these days. In the past, people in charge of our most successful companies tended to have too much money to spend and too much faith in their ability to generate adequate returns from foreign acquisitions. Takeover disasters, from National Australia Bank’s US$1.7 billion grab of the US-based lender Homeside in 1997 to Crown’s $747 million purchase of three US casinos in 2007-08 that resulted in all money spent being written off, have taught Australian management that foreign takeovers are perilous. They now prefer organic growth as their overseas strategy. In 2012 and so far in 2013, Australian companies have only conducted foreign takeover deals worth US$6.5 billion, compared with the $32 billion worth of foreign deals they struck in 2011 alone, according to Fidelity’s count. The drop in overseas takeovers is even more startling when you consider that a high Australian dollar over that time made acquisitions more compelling.
Oddly enough, Australian managers are adroit at expanding abroad via organic growth because they come from a country of high labour costs. To compensate for this, they have generally perfected other aspects of running their businesses. Thus, when they arrive in lands of cheap workers, they come with competitive advantages. That’s why the list of companies that do well overseas is expanding. Commonwealth Bank of Australia, Australia & New Zealand Banking and Westpac Banking are spreading through Asia. Telstra is the No. 1 mobile provider in Hong Kong under its CSL New World subsidiary and is investing in China. Woodside Petroleum, Oil Search and Origin Energy are venturing profitably into the Middle East while Origin and Santos are penetrating China. CSL is a global leader in blood products and is the largest supplier of albumin in China. Goodman, one of the top-two industrial developers in the world, is the partner of choice for sovereign wealth funds wanting to invest in industrial property. 21st Century Fox, the spinoff from Rupert Murdoch’s News that is about one-third listed in Australia, is one of the world’s ablest content suppliers of sport, movies and news. Westfield is the foremost developer of high-end shopping centres around the world. QBE Insurance and Macquarie Bank, having made foreign acquisitions some years back, are squeezing these assets harder. Brambles is expanding its CHEP palet business in eastern Europe and Asia (though its growth in the US has been boosted via a recent takeover). Amcor has a substantial business in Europe as does Insurance Australian Group in Asia. Crown is building casinos in Asia with partners, the latest development being in the Philippines capital, Manila. Coca-Cola Amatil is selling its drink and food products in Indonesia. Flight Centre is one of the more prominent travel agencies in the UK and is building a presence in the US. James Hardie is the chief fibre-cement maker in the world. ResMed is the global brand for products to address sleep-disordered breathing. Seek is the biggest internet job-lister in Asia and is expanding in Latin America, even Africa. Navitas has cornered the market for providing services to the world’s tertiary educators, nimbly exploiting the global demand for an education in English and the need the world’s best universities have for cash. It is estimated that Australia’s top-200 companies already earn about 40% of their revenue from abroad. As this percentage grows, so too will returns for their shareholders.
The last reason for keeping faith in the outlook for Australian equities is the perhaps most obscure of all. China, for all its poverty, has plenty of rich people, including more than 315 billionaires at last count. They want to protect themselves by parking some of their wealth in countries where property rights are upheld by impartial and transparent legal systems. The more uncertain China’s economic and political outlook becomes, the keener they often are to whisk money out of China. Among their favourite investments are property, especially in Australia, Canada and Singapore. Mainland Chinese are now among the biggest sources of foreign investment in real estate in Australia. Stats from the Foreign Investment Review Board show mainland Chinese bought $4.2 billion worth of real estate last financial year, to be the third biggest source of funds. (US citizens and Singaporeans were first and second.) They purchased $4.1 billion worth of real estate in 2010-11, to be the second-biggest source. (The British were first.) So far this year, property developers report robust sales of new developments, thanks to Chinese buying, so that’s a small direct prop for the stock market. A bigger one from this flood of mainland Chinese money is the indirect benefit housing development provides for the overall economy, which supports domestically attuned stocks.
While Australian stocks would do better if China’s economy could, somehow, again achieve sustainable growth rates of 10%-plus a year, Australian equities should do well enough anyway without too much help from China.
We thank Kate Howitt, Portfolio Manager of the Fidelity Australian Opportunities Fund for these comments
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