Price/earnings for most cyclical and most defensive crops. Source MSCIBarra, JP Morgan.
Price/earnings for most cyclical and most defensive crops. Source MSCIBarra, JP Morgan.

Slow rebound in markets

Column by Justin Scattini.

HOPES of imminent policy intervention in both the US and euro area are helping stocks offset a disappointing economic backdrop. The combination of low, below-trend economic growth, super-easy monetary policy, and a postponing of fiscal problems in the US and Europe has supported a strategy focused on mid-risk assets.

This has involved riding a course between cash and government debt with moderating returns on the low-risk side, and deep cyclical stocks on the higher-risk side. That is, holding better-yielding corporate interest rate securities and stocks with greater earnings certainty.

The universe of listed interest rate securities has continued to expand with investors now able to build a meaningful portfolio from issuers operating in a diverse range of sectors, including banking, insurance, utilities, energy and consumer spending. Our preferred investment-grade securities include those issued by Commonwealth Bank, Woolworths, AGL Energy, IAG and ANZ.

Large cap stocks such as the major banks, Coca-Cola Amatil, CSL, Telstra, Transurban, Wesfarmers, Woolworths and property trusts such as GPT and Dexus have performed admirably over the last couple of months given their more stable earnings profiles. We retain a bias to holding these stocks given uncertainty around crisis resolution is likely to remain for a while yet.

In the lead up to reporting season, earnings adjustments have been biased to the downside, with consensus forecasts for earnings growth in the 2012 financial year falling from +7% at the start of the year to now sit at -2%. Adjustments have been most dramatic in the cyclical sectors - materials, consumer discretionary and industrials. It is difficult for sectors to outperform when profit forecasts are being cut, as we have seen recently.

 

MINING STOCKS: Following on from this, a frequent question we receive is about the apparent value of mining stocks following a period of underperformance. Key themes this reporting season in the mining sector are likely to be a focus on balance sheets, cautious outlook commentary, and potential project deferral announcements.

Longer-term we think that the mining sector is undergoing a more lasting de-rating, which goes beyond near-term economic drivers. Investors appear less willing to pay for the theme of urbanisation in developing economies as commodity consumption has caught up and the supply-side response of new mining projects clouds the picture.

It is feasible then that mining stocks will continue to trade cheaply against consensus and recent valuation levels. But on a number of measures the de-rating has already gone a long way, as illustrated by the chart above, which plots the path of price/earnings ratios over a number of years for the most defensive and cyclical stocks.

Defensive stocks have retained their price/earnings ratio of around 15 times, while valuations for large mining stocks have become more attractive. On this basis we recommend retaining an exposure to the sector through the bigger names such as BHP Billiton and Rio Tinto, where valuation support is easier to define.

Justin Scattini is a Representative of Ord Minnett Ltd, AFS licence 237121.  Justin can be contacted at jscattini@ords.com.au or 07 5430 4444. This article contains general financial advice only and does not consider your personal circumstances; you should determine its suitability to you.  Before acquiring a financial product you should consider the relevant product disclosure statement.  Past performance is not a reliable indicator of future performance.
 


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