How to make money in the new financial year

This article appeared in the June 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.

Diversifying away from the Top 10 stocks could make a big difference to returns in the next two years.

Photo of Mike Hawkins By Mike Hawkins, Evans & Partners

The Australian sharemarket is ambling through Financial Year (FY) 14. Having re-rated strongly through the 2013 financial year as valuation (PE) multiples expanded, the market was left dependent on earnings growth to drive ongoing performance.

As has been the case since 2009, earnings momentum is proving elusive and we strongly suspect that this will remain the case in the coming financial year.

More broadly, shares have entered a typical late cycle phase characterised by:

  • stretched absolute valuations
  • emerging cost/margin pressure
  • escalating corporate activity (for example, more takeovers)
  • and rising interest rates led by the US.

Although this phase may yet take two to three years to play out - clearly interest rate pressures are a long way from being restrictive - we still feel investors should approach the coming financial year with a degree of caution. Distortions, in both asset class valuations and investor behaviour caused by the lengthy duration of the zero interest rate regime in the major developed economies, continue to evolve.

For the Australian market, the still-sluggish earnings environment remains the more immediate challenge, with consensus expectations that the ASX 200 will deliver about an 8 per cent lift in profits in both FY15 and FY16 looking optimistic.

Economic backdrop is mixed

The mix of economic activity is clearly moving in a more favourable direction for the listed sector than has been the case over recent years (such as more mortgage lending and residential construction), but the aggregate picture still fails to inspire, particularly with faltering terms of trade to keep nominal economic growth around 3 per cent.

In combination with the stubbornly high Australian dollar, the pronounced weakness in bulk commodity prices so far in 2014, the limited scope for the Reserve Bank to deliver further interest rate cuts and the high relative cost of doing business in Australia, the broader macro environment is still far from optimal in regard to driving strong profit growth.

It was in this environment that the Federal Government delivered a relatively stringent Budget. There is never a perfect time to pursue structural fiscal repair. The restrictive impact of the Budget initiatives across FY15 and FY16 is not ideal, but the lift in infrastructure-related spending should deliver two medium-term benefits: a more productive and efficient capital stock and a strong activity surge through to FY18, to counter the large decline in mining/energy project investment.

We estimate the combined impact of new spending and revenue initiatives announced in the Budget will have a net restrictive impact on the economy equivalent to about 0.2 per cent of gross domestic product in FY15 and about 0.4 per cent in FY16.

Disposable household income under pressure

However, initiatives that will directly impact household spending power - a more relevant metric for share investors - are more meaningful and equate to about 0.3 per cent of household disposable income in FY15 and about 0.8 per cent in FY16.

For at least the past 20 years, the mid-to-lower segments of the household income distribution have been net beneficiaries of government policy change. The fact that this segment is captured by the fiscal repair initiatives in the latest Budget (Senate permitting) increases the likelihood that the detrimental impact on household disposable income will flow through into actual household consumption - that is, unlike the upper end of the income distribution, the mid-to-lower segment does not have the scope to reduce savings.

To the extent that the mid-to-lower segment has a savings buffer to access, we also suspect the policy changes will increase this segment's propensity to save and thus exacerbate the negative impact on household consumption (and discretionary retailing) during FY15 and FY16.

However, the removal of the carbon tax and the resulting step-down in energy costs would partially alleviate the hit to the mid-to-lower income segments.

China remains a key risk

Another material risk overhanging FY15 and FY16 earnings estimates for the ASX 200 is China. The incremental news flow (and commodity prices) continues to suggest that the Chinese economy - which has become increasingly debt-dependent over the past five years - is confronting a genuine credit squeeze.

The backdrop is a Chinese reform agenda attempting to curtail overcapacity (steel, cement, aluminum, residential housing), environmental decay, corruption, wealth inequality and transition the economy away from heavy industry/exports. These are challenges that have flowed from the easy access to credit/misallocation of capital and it is not a given that the Chinese leadership will look to counter the structural adjustment that the credit squeeze will deliver. They will certainly seek to avoid a crisis but they will not avoid pain, particularly for certain provinces and industries.

Share investors and mining companies expecting a quick return to the glory days will continue to be disappointed. For an increasingly China-dependent Australian sharemarket, the challenges facing China warrant a more conservative pricing of risk than that implied in current valuations.

China is facing a series of interrelated structural challenges that will take a committed reform agenda and time to address.

Achieving decent returns in this environment

Active portfolio management is critical to the delivery of your investment objectives. For shares, the bottom line of your portfolio in terms of earnings/cash flow generation, quality, risk (industry diversification, leverage, liquidity, etc.) and valuation, needs to be constantly reviewed and enhanced.

With the 2014 financial year drawing to a close, it is an optimal time to undertake this exercise, particularly from the perspective of assessing how your portfolio is placed in terms of earnings/cash flow generation in the next two financial years.

When undertaking this exercise recently we were immediately struck by the extent to which the Top 10 stocks in the market - which typically command an allocation of about 40 per cent in a portfolio - will be a liability. Excluding CSL, the one major exception, the average earnings growth for the Top 10 across in the next two financial years is just 4 per cent (Source: Bloomberg).

By definition, if the earnings outlook for the Top 10 (about 53 per cent of ASX 200 capitalisation) is soft, so it will be for the overall market. Thus, a large portfolio exposure to the Top 10 stocks may not necessarily ensure relative underperformance, but it could, in our view, constitute a missed opportunity.

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

Stocks outside the Top 10 stocks that can deliver a superior growth profile over the next two years will clearly do better - more so because their valuation is generally more conservative than that of the Top 10, which we view as expensive.

Sectors to watch

Basically, moving into FY15 a hefty portfolio exposure to the Top 10 stocks will come with a high opportunity cost. In looking for alternative investments that can deliver a superior lift in profits, and share price, over the next two to three years we would look first to healthcare, logistics, infrastructure and A$-exposed global industrials.

The Australian dollar remains materially overvalued relative to Australian macro fundamentals - and increasingly those of China. Further weakness is inevitable over the coming years, with the turning point in US interest rates, a critical event for global markets in FY15, a key catalyst.

Thus, my key messages for next financial year are:

  • Shares are entering a typical late cycle phase. A more cautious approach is warranted.
  • Don't get caught with an expensive portfolio in an expensive market.
  • In this regard, diversify away from the Top 10 stocks, which are expensive, particularly relative to their subdued growth outlook, according to Evans & Partners.
  • If you have not already done so, diversify into global sharemarkets where quality, opportunity and value are superior to that of the ASX 200. (Editor's note: investors can use ASX-listed exchange products and listed investment companies for exposure to offshore sharemarkets).
  • Australian Government bonds are now listed on ASX. If we were to see yields of 4.5 per cent or more in the next financial year, then buy.

About the author

Mike Hawkins is Chief Investment Officer at Evans & Partners, a leading wealth-management firm.

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