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Sectors to watch this year

This article appeared in the February 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

There will be plenty of opportunities to make money this year, even after two strong years of returns for share investors. Focus on buying businesses that will grow long into the future and survive whatever gets thrown at them - and keep an eye on the sector outlook.

Photo of Nathan Bell By Nathan Bell, Intelligent Investor Share Advisor

It was a good year for the sharemarket in 2013, with the All Ordinaries Accumulation Index (which assumes dividend reinvestment) up 19.7 per cent following an 18.8 per cent increase in 2012. The bounty was widespread, with 11 of the market's 15 sectors producing positive returns, as Chart 1 below shows.

Provided you were not heavily invested in resources or mining and engineering services companies, which should generally be left to investors with large risk appetites given their exposure to volatile commodity prices, your portfolio should be looking healthier as we enter 2014.

Chart 1: Best-performed ASX sectors in 2013
- 2013 Sector performance(%)

 Best performed ASX sectors in 2013

Source: Intelligent Investor

Health Care sector valuations soar

The Health Care sector was the year's best performer, producing a 41 per cent return. A combination of steady and in some cases rapid earnings growth saw valuations soar. Ramsay Healthcare was the hero of the sector. Its share price increased 59 per cent and currently trades on a forecast price-earnings (PE) ratio of 28.

Few large businesses can justify that sort of PE multiple, and while we are wary of the dangers of underestimating such a high-quality business, there is no margin of safety at current valuations.

(Editor's note: Do not read the following commentary as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).

We own CSL, Sonic Healthcare, ResMed and Cochlear in our model Growth Portfolio but only respiratory device manufacturer ResMed currently sports a positive recommendation, as the rest are close to fully valued.

We would love another opportunity to invest in any of these companies at a cheaper price, but even though ResMed's PE ratio above 20 also seems high, we believe this market leader has many years of rapid growth ahead as it capitalises on the increasing awareness and treatment of sleep apnoea. It also has nearly $1 billion in cash sitting on its balance sheet, ensuring that any product recalls or other temporary problems can be dealt with from a position of strength.

Financials and other outperformers

The four other heavily weighted sectors in the index that outperformed included Financials, which is dominated by the banks and produced a return of 31 per cent; Telecommunications, up 30 per cent; and the Consumer Discretionary and Staples indices that produced 27 per cent and 25 per cent returns respectively.

Although National Australia Bank is the cheapest of the big four banks statistically, we prefer Commonwealth Bank and Westpac because they have not taken large risks abroad and instead continue to benefit from their regulated oligopoly at home.

We also prefer the big four banks to the regional banks, as they are more likely to receive financial support in a crisis, as they did in 2009, and rely less on certain geographies. Our model portfolios have very little exposure to the banks, because they have become expensive and will be sensitive to the eventual slowing of the Chinese economy.

We have positioned our portfolios away from stocks heavily reliant on strong growth in the Australian economy, and towards businesses such as 21st Century Fox and Macquarie Group that have large overseas exposure, to take advantage of a falling Australian dollar and the slowly recovering Western economies abroad.

Telecommunications

The Telecommunications sector is heavily weighted towards Telstra and Singapore Telecommunications, but the performance of the mid-cap companies, such as TPG Telecom and M2 Telecommunications, whose share prices increased 105 per cent and 50 per cent respectively, was remarkable.

Our preferred pick is M2 Telecommunications. Its forecast PE ratio of 13 is well below that of its peers, management has done a good job integrating acquisitions, and growth from its internet and mobile businesses should offset declines from its more obsolete services. There is also room to cut costs further, which should help increase margins and profits.

Retail

We have largely steered clear of the Discretionary Retail sector. While it has enjoyed a handsome rebound from 18 months ago when investors feared the Australian economy was going to hit a wall, the long-term structural threats to businesses such as Harvey Norman, JB Hi-Fi and Myer from the likes of Amazon and Apple, and an influx of luxury fashion labels from overseas, remain. As Warren Buffett once said, it's hard to pay a low enough multiple for a business in decline.

The Consumer Staples sector should continue to plod along, but with valuations increasing we expect more of our returns to come from dividends than capital growth. Our preference is Woolworths, which offers a 3.9 per cent fully franked yield, which is not bad given we expect interest rates to remain relatively low for some time as a result of Australia's high consumer debt levels. One of our biggest concerns with Woolworths is management making a large and misguided acquisition overseas.

The year ahead

Ordinarily, as bottom-up value investors, we analyse businesses on a case-by-case basis rather than focusing on rotating money by sector. But the collapse in share prices in the Gold sector should pique the interest of speculators that do not mind punting with money they can afford to lose.

Given the risks, we recommend taking a portfolio approach. Beadell Resources, Kingsrose Mining, Northern Star Resources and Silver Lake Resources are currently on our buy list, but with very low recommended maximum portfolio weightings.

In 2014, merger and acquisition activity could increase as companies grow more confident and consider making use of their strong balance sheets. Rather than trying to pick targets, Macquarie Group and Computershare should do well if corporate activity picks up. Macquarie looks fairly valued, but Computershare is a relatively low-risk way to play this trend should it eventuate.

If not, they are still the type of blue-chip companies that can form the bedrock of a high-quality portfolio. Computershare should benefit as the US economy recovers and interest rates rise.

Dividend yield

Lastly, investors searching for a mix of yield and growth might consider Sydney Airport. While not screamingly cheap, it offers an unfranked 5.9 per cent distribution yield and should be able to grow profits for decades to come.

Air travel is becoming cheaper, more and more airlines are offering more services than ever before, and Australia remains a popular tourist destination. Sydney Airport also has first right of refusal over a second airport in Sydney and it is much more profitable than an airline.

No one knows what the future holds, but the difference between 2014 and previous years is that share prices are generally factoring in blue skies ahead. That is usually a sign to check your portfolio limits and take some chips off the table, particularly if you have profited from owning some risky businesses, and keep some cash handy to take advantage of opportunities.

It may seem strange to those without a contrarian bent, but this year I hope there are a number of earnings disappointments. Australia boasts scores of well-run, highly profitable businesses that we would love to own at the right price. With expectations currently so high, there are bound to be some opportunities as various companies disappoint investors who are short-term focused.

Slower-than-expected economic growth in China would certainly bring this about, but it is impossible to know when this might happen. As a result, we remain focused on buying businesses that will grow long into the future and survive whatever gets thrown at them.

Provided you have tempered your expectations after two highly profitable years, this simple strategy should ensure you make the most of the opportunities that 2014 has in store.

About the author

Nathan Bell is Research Director of Intelligent Investor Share Advisor. You can unlock all of Share Advisor's stock research and buy recommendations by taking out a 15-day free membership. This article contains general investment advice only (under AFSL 282288).

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