Lincoln's best stock picks for 2013

By Tim Lincoln, Lincoln Indicators

The performance of the Australian sharemarket has largely been on par with global counterparts in 2012. A number of macroeconomic problems have sapped investor confidence, but the investment thesis for investing in Australian shares remains.

Lincoln analyses companies first and foremost for what we call Financial Health. We measure 12 accounting ratios to assess a company's level of insolvency risk. Every company on ASX has its profitability, cash flow and balance sheet positions scrutinised and a holistic Financial Health score is determined. Companies with a Strong or Satisfactory score are judged as being exposed to acceptable levels of risk and should make up the bulk of your investment portfolio.

Companies with an Early Warning, Marginal or Distress score carry escalating degrees of risk and should be avoided by risk-averse investors. Armed with the ability to properly assess a company's Financial Health, investors gain greater confidence and control over their investment portfolios. Here is our assessment of the health of the Australian sharemarket in mid-November.

Health of the market pie chart - as at 19 November 2012

Source: Lincoln

A timely reminder of the risks investors face with investing in unhealthy businesses came to the fore in 2012 when two businesses that once had $1 billion-plus market capitalisations folded. Tasmanian timber company Gunns Limited (GNS) and Australia's largest commercial refrigeration company, Hastie Group Limited (HST), succumbed to overladen debt burdens and cash flow problems.

Hastie and Gunns had been in poor Financial Health since 2005, as the charts below show. Gunns, however, was once a Stock Doctor Star Stock until it was removed from the list in February 2005.

Hastie Group and Gunns line charts - 2005 to 2012

Source: Lincoln's Stock Doctor

Unlike these high-profile examples, the majority of companies that fail are in the smaller end of town and often go unnoticed into obscurity. But again, despite the high risk, many investors jump in totally unaware of the risks they are taking. And no company can be considered a sure bet.

Take defence technology company Metal Storm Limited (MST) for example. Despite once reaching the heady heights of a market capitalisation of $600 million in 2001, MST has shown poor Financial Health since its listing in 1999. The company often successfully raised capital despite this. Perhaps investors thought a company that produced a weapon that could shoot a million rounds a second could not go under. Eventually, years of poor profitability and high debt led to its fate.

What has been just as worrying is the trend in the health of our market. Based on Lincoln's empirical studies over the past 14 years, the proportion of companies in Strong and Satisfactory Financial Health positions has fallen from 49 per cent of the market in 1999 to approximately 27 per cent in November 2012.

Our studies note that the health of the market is generally a leading indicator of market events and this was evident when the market's Financial Health declined during the bubble before the onset of the GFC in 2007. At the other end of the spectrum, companies that are in either in Distressed or Marginal positions have risen from 44 per cent to 64 per cent, and those in Early Warning positions increased from 7 per cent to 8 per cent.

This indicates that approximately 72 per cent of companies in the market are currently deemed to be high-risk investments. This should serve as a warning to investors to conduct a thorough and careful review before making any decisions.

Health of the market - 14 year comparative line chart - June 1999 to June 2012

Source: Lincoln's Stock Doctor

Deterioration of the general health of the market can be linked, in part, to the rise of the resources sector. It has historically shown signs of declining levels of Financial Health because of the addition of many speculative explorers listing in an attempt to take advantage of the commodity cycle. Now this cycle is maturing, many of these non-profitable explorers in poor Financial Health are under increasing pressure.

Lincoln expects the downward trend in Financial Health in mining and energy sectors to continue into the New Year but to stabilise and eventually recover as these unprofitable participants withdraw from the market. Despite the subpar prognosis, little gold nuggets remain for those willing to find them.

Healthier sectors

Sectors in the healthier parts of the market include consumer discretionary, financials and telecommunications. The Financial Health of consumer discretionary companies improved over the past year, rising from 53 per cent to 58 per cent. This is consistent with latest announcements from financially Strong companies such as Super Retail Group (SUL) and ARB Corporation (ARP), both reporting earnings uplift despite operating in difficult conditions.

We attribute the improved health in this sector to the consolidation and exit of previously weak retailers that struggled in the challenging conditions, such as Clive Peeters, Retravision and Colorado.

Financials was also among the improved sectors, with the level of financially acceptable companies up from 45 per cent to 47 per cent. This comes as no surprise, as a large number of listed investment companies (LICs) and real estate investment trusts (REITs) have been in a process of refinancing their balance sheets and lowering gearing levels since the GFC. The health trend in this sector is expected to improve as LICs and REITs deleverage further.

Overall, the health of the telecommunications sector has been Strong, in part due to the level of consolidation as larger and more financially healthy companies buy out smaller, less efficient ones, particularly in the ISP market. The level of financially acceptable companies rose from 38 per cent to 50 per cent this year. Growth in the sector was also underpinned by increasing valuations for Telstra Corporation (TLS), along with a number of positive earnings reports from the likes of TPG Telecom (TPM), iiNet (IIN) and M2 Telecommunications Group (MTU).

Australia's ride on the commodity cycle has slowed down dramatically and investors are increasingly trying to find value in other, less-volatile, sectors of the economy. Despite the generally poor but improving Financial Health of the market, opportunities still exist. Although every industry will have its share of winners and losers, prudent investors can limit their exposure to the downside by investing in a portfolio of companies that exhibit Strong or Satisfactory Financial Health, to maximise long-term growth.

Here are Lincoln's top 10 Financial Health picks for 2013:

1. AP Eagers (APE): Strong

Both a Star Stock and a Lincoln preferred income stock; APE is a motor vehicle dealership with exposure in property. Profit growth in FY13 will be driven by recovery of new vehicle supplies and earnings contribution from acquisitions. Strong cash flows along with profitability and moderate gearing indicate the company will be capable of paying steady and increasing dividends.

2. Ardent Leisure Group (AAD): Strong

A specialist operator of leisure and entertainment assets across Australia, New Zealand and the United States, AAD is prized for its Strong Financial Health position and above-market yield. Consistent operating cash flows ensure a healthy dividend, with a current gross yield of approximately 8.9 per cent, sourced from an increasingly diversified revenue composition.

3. BWP Trust (BWP): Strong

A Lincoln preferred income stock; BWP is a real estate investment trust offering a distribution yield of around 6.5 per cent. BWP's properties are exposed to a quality anchor tenant, Bunnings Warehouse, with full occupancy rates and relatively long weighted average lease terms (7.7 years as at end of FY12). Yields are expected to improve from a recent Gladstone property acquisition and rental increases from market rent reviews.

4. Crown (CWN): Strong

CWN is a casino operator with primary assets in Melbourne, Perth and Macau. The company grew earnings by more than 50 per cent in FY12, driven by growth in gaming ventures in Macau. The large amount of capital expenditure on refurbishing the Melbourne and Perth assets will provide a springboard for 2013 earnings. A Strong Financial Health position means Crown is less risky than the services it provides.

5. M2 Telecommunications Group (MTU): Satisfactory

MTU is a telecommunications company operating in the SME, retail and wholesale space. FY13 revenue is expected to grow by up to 60 per cent (between $610 million and $650 million) with underlying net profit to be in the vicinity of $55 million to $60 million. A financial healthy business, the company remains well placed to take advantage of the National Broadband Network (NBN) and its recent acquisition of Primus opens up residential market exposure.

6. Mermaid Marine (MRM): Strong

A current Stock Doctor Star Stock, MRM is a vessel operator with a distinct competitive advantage (with the Dampier supply base) for the offshore energy sector. With continued investment and development activity in major LNG projects off the North West Coast, MRM stands to benefit from increased activity levels. The business has a strong track record in terms of fundamental performance and is set to continue this trajectory.

7. PanAust (PNA): Strong

A current Stock Doctor Star Stock, PNA is a financially healthy copper and gold producer primarily operating in Laos. Its flagship asset, the Phu Kham copper-gold project, has a strong record of ongoing efficiency improvements at this mine. Strong contributions are expected from the recently commissioned Ban Houayxai gold-silver operation and we expect strong growth from PNA this financial year.

8. ResMed Inc. (RMD): Strong

A global supplier of medical products to treat sleep apnoea, RMD reported a strong first-quarter update with 40 per cent uplift in profits and improved profit margins. Prospects are promising, with increased awareness of sleep apnoea potentially leading to more diagnosis and treatment.

9. Roc Oil Company (ROC): Strong

A Stock Doctor Star Stock, ROC is an oil and gas company with a main focus in Australia, China, United Kingdom and South-East Asia. ROC achieved a high level of success with its drilling results at the Beibu Gulf project. Production from the asset is expected to begin in early FY13 and this should translate into strong results in FY13 and FY14. There is potential for further upside to resource reserves and production estimates as further exploration wells are being drilled.

10. Wesfarmers (WES): Strong

A candidate for investors with both income and growth focus, WES is a conglomerate with exposure to consumer staples, consumer discretionary and industrial sectors. Its first-quarter sales update signals continued growth in its retailing operations. The company grew earnings by 16 per cent in the 2012 financial year and we expect similar growth into the 2013 financial year despite some concerns about its coal operations.

About the author

Tim Lincoln is managing director of Lincoln Indicators, one of Australia's premier fundamental analysis research houses and fund managers, offering intelligent sharemarket solutions for the conscientious investor.

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