OPINION: What's ahead for Australian equities?

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Fidelity’s Australian head of equities and portfolio manager Paul Taylor picks out the sweet spots and the structurally challenged sectors of the market, and says there are reasons to be optimistic this year.

The current market recovery is starting to resemble those that followed the long bear markets post the 1987 crash and the mid-1970s oil price shock, some five years after the original correction, the market finally started to recover. This could be coincidence, or the common theme could be that even after major imbalances, which contributed to the original correction in share prices and subsequent market weakness, the problems were starting to be dealt with after five years - even in the most protracted previous instances. If the latter proves to be correct, it bodes well for the market in 2013.

The Australian equity market delivered close to a 20% total return (capital plus dividends) last year and I would be looking for a similar positive outlook in 2013. Australian market valuations remain attractive from a medium to long-term investment perspective with a lot of bad news factored into share prices. As cash rates and term deposit rates continue to decline, the significant dividend yield of the Australian equity market looks increasingly appealing to investors seeking income returns, especially as they arrive with attractive franking credits. Furthermore, dividend yields in Australia, which are among the highest in the world, appear to be sustainable given strong corporate balance sheets and free cash flow levels. Buying bank shares with attractive dividend yields and franking credits is still a superior risk return investment than putting your money in that bank’s term deposits even in a lower growth environment.

The US and China are looking much more encouraging now than they were at the start of 2012. Europe remains in a difficult spot and will likely take a long time to work its way out of the sovereign debt crisis, but the central authorities have done their best to try and take the worst-case scenarios off the table. We are likely to see flare-ups continue to come out of Europe in 2013 but these will probably be great long-term investment opportunities.

What sectors and companies do you prefer?

While the market is looking positive for 2013, as always individual stock selection is critical. Those companies that can deliver growth or a high and sustainable dividend yield or both will continue to be bid-up by the market in this environment. I would expect to see earnings upgrades for the Australian market as we start to see the benefits of lower interest rates working their way through the economy. At an industry level I remain positive on industrials, diversified financials, insurance, telecommunications, property and healthcare as these sectors will likely have strong and growing cash flows in 2013.

There are a number of stocks and industries that are currently structurally challenged. These would include manufacturing, some discretionary retail and media and would probably represent the most depressed share prices. These headwinds are likely to remain for the foreseeable future. To achieve growth in dividends these companies need to repair their balance sheets and grow their free cash flow - which will be difficult to achieve whilst facing these structural head winds. The focus on the resources sector will likely move away from commodity prices and towards the cost of production or the cost curve. The low-cost producers will have a sizeable advantage in this environment. The larger, more diversified resource companies such as BHP Billiton are generally better positioned on the cost curve than many of the smaller players.

Will the hunt for yield continue?

The hunt for yield will continue in 2013. We are currently in a low-growth world. This low-growth environment is not just here for the next year but will likely prevail for at least the next five years. In a low-growth world, companies that can deliver a sustainable yield combined with structural growth are the real sweet spot. Interest rates are also likely to come down further in 2013 further compressing yields and pushing up the valuation on those assets that deliver sustainable yield.

What are your expectations for corporate activity?

I believe it will remain difficult to get capital raisings and IPOs away this year. In the IPO market investors will likely remain discerning and only companies with strong business models would be expected to be brought to the market. Capital raisings will similarly be heavily questioned. In 2013 investors will continue to demand higher dividends, capital returns and share buybacks with only the strongest business cases getting allocated new equity.