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Lincoln: Top stocks for the new financial year

Photo of Elio D'Amato By Elio D'Amato

min read

Dividends the key over next 12 months, as earnings growth slows.

Tax time presents investors the opportunity to consider the future, and position equity investments for a new financial year to provide the greatest potential to achieve investment objectives.

There has been much posturing from market participants on the level of value in the sharemarket. Before I explain my views on that, I want to remind readers that the Australian market is attractive given the current economic cycle. Low interest rates, falling input costs and taxes, and a lower Australian dollar have created opportunity for a number of businesses.

The path to success in this market will be knowing which businesses are right for your portfolio. That sounds simple, but there is more to it, and I hope to put you in a better position to review your portfolio and make controlled, confident investment decisions for the next financial year.

So, is the market expensive? I would contend that it is, but its price is justified. Let’s start by looking at historical price-earnings (PE) ratios.

Source: Lincoln

The chart above shows the PE of the ASX 200 has been rising since the beginning of 2012 and now appears to be near the top end of its range. So on a PE basis, the market is expensive. But there is a reason.

First, equities as an asset class are more attractive than ever, with the ability to provide investors with income (through dividend yield) and capital growth.

Second, the economic factors mentioned earlier (the lower dollar, interest rates and input costs) are affording corporate balance sheets additional comfort.

Lincoln continually monitors what it terms the Financial Health of every company on ASX, and has found that the market is fraught with danger: almost 75 per cent of the market fails to satisfy Lincoln’s Financial Health check and is therefore exposed to unacceptable levels of risk. (Editor’s note: this is partly because of the high number of loss-making junior exploration companies on ASX).

This might be discouraging to investors, but the good news is that if you pick companies that are profitable, producing strong cash flows and have the balance sheet strength to support future ambitions, outperformance should become an expectation for your portfolio. There are plenty of positive catalysts for businesses that are doing things right, so let’s focus on them.

Looking forward to the 2015-16 financial year, Lincoln Indicators is expecting another positive year for the Australian sharemarket. I have mentioned the compelling reasons that will continue to support equity prices, but it is important to underline that the attractiveness of the market is also driven by the existence of top-quality businesses with growing earnings and cash flows that have the financial propensity to reward investors.

The outlook for earnings

The outlook for 2015-16 earnings is a key consideration. Earnings and share prices are highly correlated, so a good method for assessing the future prospects of the market is to use bottom-up analysis and assess forecasts for earnings going forward.

Anecdotally, and acknowledging that past performance is no indicator of future performance, great examples of the link between share price success and higher long-term earnings per share (EPS)  growth rates include REA Group, CSL and the lesser known perennial performer Technology One. These are examples of companies in Strong Financial Health that are delivering on EPS expectations and rewarding shareholders.

These are the types of companies you should be looking to invest in if you consider yourself a growth investor.

The table below shows the market earnings per share forecasts, as well as a sector breakdown. It is not hard to see where the growth is expected. Infotech, industrials, healthcare, and consumer discretionary are the standouts, with healthcare the most expensive on a leading PE basis.

Overall market expectations are for mild growth in earnings per share. This is no surprise, as the biggest sectors in our market are expected to perform mildly, with low or negative EPS growth forecasts for financials, materials and energy the key drivers.

Sector Name Sector index price Sector earnings per share grwth (forecast) Implied leading sector PE
S&P/ASX200 (XJO) 5637.5 1.85% 16.26
Con Disc 1964.3 33.38% 17.57
Con Staples 9155.7 24.99% 17.14
Energy 11348.6 -6.89% 19.49
Financials 6420.3 0.10% 14.04
Healthcare 18231.4 26.43% 22.19
Industrials 4755.8 69.33% 19.08
Infotech 803.8 104.71% 18.05
Materials 9394.4 -21.91% 19.73
Telecomunications 2188.8 0.80% 16.95
Materials 6507.3 -19.28%  20.00

Source: Bloomberg

The outlook for dividends

As mentioned, equities are the key asset class for those looking to generate income from investments in the current economic climate. What is more, the current economic climate is not about to experience a drastic change. Market expectations suggest the official cash rate is unlikely to lift above 2 per cent in a meaningful way for close to two years.

This sets the scene for a supportive sharemarket when it comes to income stocks. Lincoln’s own Lincoln Australian Income Fund is targeting an after-tax (grossed-up for franking credits) income to investors of between 7 and 7.5 per cent for the 12 months to 30 April, 2016.

Source: Lincoln

In the above chart, it is evident that the disparity in income returns between the one-year bank bill and the Australian equities market is continuing to widen to historic highs. So while income-oriented companies such as banks may have low growth forecasts in terms of earnings and dividends, prices should be well supported by investors who have no choice but to allocate a sufficient amount of their exposure to equities to meet required income targets.

In short, dividends should continue to support prices in these lower growth, but higher dividend payout, companies.

Will the market pass the 6000 mark?

Lincoln believes the market remains in Stable Financial Health. There has been some deterioration in certain sectors, particularly those relating to commodity prices, but the overall economic situation remains supportive of continued growth and justified premiums in market prices.

Be ruthless in getting your portfolio in sparkling shape, but consider your investments within the context of your objectives, and the risks in the context of your portfolio as a whole.

For income investors, the market is providing record levels of attraction compared to fixed-income securities. For those who are growth focused, there remains a wealth of good opportunities to invest in growing innovative businesses.

Below are three growth stock ideas and three income stock ideas. It is hoped this gets you started on a journey to a better equities portfolio and a successful 2015-16.

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

Stock Doctor Star Income Stocks

Code Name Financial Health Sector
AHG Automotive Holdings Group Limited Strong Consumer Discretionary
TLS Telstra Strong Telecommunications
ARF Arena REIT Strong Financials - REITS

Stock Doctor Star Growth Stocks

Code Name Financial Health Sector
MFG Magellan Financial Group Strong Financials
CCP Credit Corp Group Strong Industrials
WES Wesfarmers Limited Strong Consumer Staples

 

 

About the author

Elio D'Amato is chief executive of Lincoln, a leading Australian share researcher and investor.

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The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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