Today we see that so-called “defensives” are becoming more popular (i.e. expensive) as cyclical companies become unpopular (i.e. cheap). This is occurring on both local and global markets as growth concerns are at the forefront of investors’ minds.
In Australia, we see local interest rates are moving down (notably ten year bond yields to historic lows). There is ongoing pressure on the local economy as mining capital expenditure continues to fall and traditional economic drivers (especially credit fuelled consumption) struggle to generate solid growth. We therefore perceive that this will be a year of below trend GDP growth, with subpar growth in employment, low inflationary pressures (outside a weakening $A) and sluggish corporate earnings growth. Meaningful fiscal stimulus looks unlikely, however it may be necessary as the year unfolds.
Despite this we believe that local equities are likely to generate a reasonable return due to their elevated yield (plus franking) relative to alternatives such as AUD bonds, term deposits and at call cash. Our view is that the yield compression rally which commenced in 2013 may have a little further to go as the alternatives to equities offer poor real yields.
The following presents a dilemma for Australian equity investors in 2015. Yet again we are witnessing a marked deterioration in forecast earnings growth. The predictions for earnings growth in 2015 (represented by the dark blue line) that were forecast by market analysts in early 2014 have been cut back in aggressive fashion. The blue line has declined and market eps is forecast to be at the same level as 2008/09 (the purple line).
All Ordinaries
Figure 1. All Ordinaries – IBES EPS Estimates
Source. Thomson Reuters Datastream
Despite these low growth expectations, the sideways movement of the market – it is at the same level as May 2013 (20 months) and April 2006 (nearly 9 years) – means the steady retention and raising of capital by companies has lifted the market’s value despite declining returns on that capital.
Therefore we now perceive that the price of local equities has become somewhat attractive in aggregate and reasonable long term returns can be expected, skewed more to dividend income near term due to continued subdued EPS growth. Today the Australian market presents as relatively good value with other positive returns forecast for the UK market.
“We emphasise market returns in this analysis for index investors but our focus, and quite possibly your focus, should be on stock selection inside markets. To this point, we believe that many international stocks clearly present as better growth opportunities than Australian stocks. It is just a matter of being patient and picking them up when value appears. In the meantime a weakening $A will continue to support offshore cash holdings.”
By way of example, we have looked at 40 years of monthly valuations for the MSCI Australia and noted several interesting findings for index based investing:

  • The long term average return from Australian equities is 9.9%.
  • The average V/P is -5.2% reflecting marginally conservative valuation metrics and a 10% RR.
  • Markets have been more expensive post 2000, average V/P has been -11.2%.
  • The market has traded under spot valuation 34.6% of the 480 months, thus trading above valuation 63.4% of the time.
  • On 101 occasions (or 21% of the time) the market traded at >10% discount from valuation at months end, they generally arrive in clusters (i.e. sustained periods like the GFC).
  • Index investors buying at >10% discounts enjoyed an average 16.2% CAGR for the following 10 year period. On only 3 occasions did the following 10 year CAGR fall below the long term average of 9.9%, the worst being 9.4% CAGR , the best being 28% CAGR and 16 occasions producing >20% CAGR’s for the following 10 years.
  • This additional return can be termed the Value Premium and when compounded for 10 years can be significant.
  • $10,000 compounded at 9.9% for 10 years finishes around $25,750.
  • $10,000 compounded at 16.2% for 10 years finishes at around $45,000.

The real value of research is tilting the odds of success in your favour. Buying equity with a healthy margin of safety reduces risk and enhances returns. If we are lucky, 2015 will give us another opportunity when the market trades greater than 10% under valuation.
In the future we will look at how the 10 year CAGR returns fare when the market is >10% expensive and if the above Value Premium exists with the MSCI US & World markets.