Where next for shares?

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Short-term outlook mixed, but these companies can still benefit.

Photo of Geoff Wilson By Geoff Wilson, Wilson Asset Management

The strength in the sharemarket over the past few years has been driven by cheap money leading to excessive global liquidity. In my view, an overextended equity market with extremely low volatility and a relatively long bull market was due to change at some point.

The anticipation of the end to the US pumping liquidity into the system via quantitative easing (an unconventional form of monetary policy to stimulate economies) together with the deterioration in the European economic outlook, mixed in with an increase in geopolitical uncertainty in the Middle East and the Ukraine plus the Ebola outbreak, has led to the recent market fall.

Not only was the market falling or, as some market commentators have been advocating, entering the start of a correction (technically defined as a fall in the market of 10 per cent or more), but volatility has also reached its highest level since June 2012. This is illustrated by the VIX Index, based on the S&P 500 in the US and widely used as an indicator of global market volatility.

Around the world, the central banks' answer to the recent volatility in the sharemarket has been to "jawbone" about pumping more liquidity into the system. This is a concern, as the continued increase in liquidity could well lead to a bigger bubble in asset prices.

Themes for the market

Over the past few years, Corporate Australia has significantly reduced costs in an effort to boost profitability. Lower interest rates have not yet led to a pick-up in general economic activity, as shown by data points released in September, such as weak retail sales and lagging consumer sentiment surveys.

When the broader economy eventually shows strong growth, the impact on corporate profitability is likely to be significant. Simply put, revenue growth of 5 per cent would lead to a 25 per cent increase in profitability for any company that can maintain costs with a 20 per cent profit margin. The key remains the ability to predict when this will happen.

Currently, world growth is being affected by a deteriorating European economy, where the main problem is the Euro itself. Despite the wishes of some member countries to indulge in stimulatory spending or to begin quantitative easing to stave off deflation, the German Government remains committed to austerity and budget tightening, even though its economy shows symptoms of a recession.

Simultaneously, China faces a number of significant challenges as its strong growth rates decline. Its slowing economy, plagued by a slump in house prices and weak industrial production, is also leading to reduced global demand and prices for commodities, thus a lower Australian dollar.

I expect the Australian dollar to fall towards 75 cents to the US dollar. The slowdown in global growth will be a continued headwind for mining and mining-related companies.

Where is the Australian sharemarket heading?

I expect the equity market to be lower at the end of 2015 than at the start. My outlook for slow economic growth and the removal of excess liquidity globally, lies at the core of this prediction. Breaking down the factors behind the soft economy are:

  • Slowing world growth, as outlined above, led by a Europe in disarray and slowing demand from China
  • Business investment and top-line sales growth remains weak
  • Anticipation of the US and the UK starting to raise interest rates during 2015, which will eventually become a drag on global equity markets.

On a positive note, we think the medium to longer-term fundamentals of the sharemarket are more compelling. When the excess liquidity has been removed from global markets and the domestic economy shows signs of sustained growth, a multiplier effect on corporate profitability will again drive stock valuations.

Favoured themes

As stock pickers, our method is to take a fundamental "bottom up" approach to investing, usually looking to identify stocks that are under-researched and undervalued. We are currently searching for companies that can grow in a low-growth environment. In these volatile markets, we are particularly looking at companies with their own growth dynamics. Companies with the added benefit of potential windfalls from the lower Australian dollar have been a theme over the past few months.

The sectors on which we are more cautious include retail, IT, mining and mining services, which are expected to have a difficult Annual General Meeting season.

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

Specific stocks we own that would benefit from both of the above themes are:

Slater & Gordon (SGH)

Slater & Gordon is based in Australia and the UK. The law firm specialises in insurance litigation, commercial and family law. Over the past two years its share price has increased from $2 to $6, driven by strong earnings growth while successfully expanding overseas. We are forecasting 15 per cent annual growth over the next two years. With 50 per cent of its earnings this financial year forecast to come from its UK-based operations, we expect Slater & Gordon to also see some upside from the weaker Australian dollar.

Infomedia (IFM)

A supplier of electronic automotive parts catalogues, Infomedia has recently launched a new version of its software that is proving to be very effective and the successful roll-out will position the business well for the future. An added enticement is that Infomedia has a majority of its earnings in US dollars.

Aristocrat Leisure (ALL)

Following the acquisition of Video Gaming Technologies Inc. and coupled with an increase in market share from competitor Ainsworth (AGI), the manufacturer of slot machines and gaming systems, Aristocrat Leisure, is well placed for growth. With around 70 per cent of its earnings in US dollars, we expect Aristocrat Leisure will experience significant tailwinds from the lower Australian dollar.

About the author

Geoff Wilson is chairman of Wilson Asset Management, a leading investment manager.

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