Last year was indeed a tough one for Australian equities.
The S&P/ASX 200 Index got off to a flying start and there was plenty of optimism that 2010 could be another strong year for the market.
Then from April, the rally started to fizzle as investors began selling down many of their holdings over fears that Portugal, Ireland, Greece and Spain may default and cause a double-dip recession.
The flagship Australian benchmark ended the year with an unremarkable 1.6 per cent gain.
And it could have been much worse if not for the resources sector's 10 per cent rally on the back of strong demand for raw materials from major emerging markets, including China and India.
While the bailout of Greece and Ireland may have somewhat calmed investors' nerves and given them more confidence about coming back and snapping up equities in 2011, market experts are urging financial planners to tread lightly with where they invest clients' money.
Big worries still linger over whether the European bailout fund will be large enough to save Portugal, Spain, Italy and Belgium from default should those nations also require emergency cash.
Ongoing concerns remain over the health of the United States and Japan, with both major economies continuing to rack up enormous debt and growing too slowly.
And to add to those largely overseas issues that nonetheless affect investor sentiment towards Australia, the local market faces its own set of unique challenges, including a two-speed economy, a new resources tax and a fresh levy arising from the Queensland floods.
There is also a structural shift in consumer behaviour that's hurting retailers and uncertainty over how local banks will navigate through the new Basel III global bank rules.
Still, despite this backdrop of headaches and taxes, some of the financial services industry's top fund managers believe the market has priced in much of the uncertainty and 2011 could be a good year for investors, provided they pick the right sectors and stocks.
Reasons for optimism
Merrill Lynch Australia strategist Tim Rocks says 2011 is shaping up to be a strong year, with the firm having a target of 5500 for the S&P/ASX 200.
"We think valuations are reasonable now. The forward price/earnings ratio for the Aussie market is just a little bit over 12. At the start of 2010 it was 15 and the long-term average is about 14," Rocks says.
"We were also concerned that earnings forecasts were too high and needed to be cut; that has basically happened. You have had a 10 per cent downgrade in earnings since the middle of 2010 and that has taken earnings back to much more normal levels."
He also says the European debt concerns are abating and so is the risk of a double-dip recession in the US.
Greencape Capital portfolio manager David Pace agrees double-digit gains are possible.
Pace says that relative to its 10-year average, the Australian market looks about 15 per cent cheap currently.
"So what I would say is to the extent that macroeconomic conditions don't deteriorate globally and further exogenous shocks don't occur, I think a 10-15 per cent gain looks achievable for the S&P/ASX 200," he says.
"On the economic front we think global economic indicators will be supportive of market returns, particularly in the first part of the year by what is quite accommodative US monetary policy and continuation of tax cuts in the US as well. "But I have got to say medium to long term we still remain reasonably cautious in part because of the growing US fiscal debt levels and what I like to call the apparent kicking of the 'economic turmoil can' down the road."
Fidelity Investments head of Australian equities Paul Taylor says he's quite positive on the prospects for Australian equities over the year ahead.
"The long-term positive fundamentals of the Australian market remain in place and valuation levels are currently very attractive," Taylor says.
"Also, Australia's strong fundamentals of high population growth, excellent and low-cost natural resource base, good corporate governance and a high dividend yield and high real dividend growth are still very much in place as we move into 2011.
"Australia, and the market, will also benefit from the high economic growth from emerging markets and the resultant positive impact on demand for resources and commodity prices."
He says there are currently many opportunities to buy great quality companies at attractive prices.
"Combining this strong growth outlook with the attractive valuation levels could well mean a strong Australian equity market performance in 2011," he says.
Resources, tax and Rio
The resources sector has faced much uncertainty in recent times.
The government sparked immense controversy after it first announced in May 2010 that it would push for a 40 per cent resource super profits tax (RSPT) on mining profits.
However, after a severe backlash from the mining industry and investors, the government a month later stepped back and watered down its proposal to the mineral resource rent tax (MRRT), which was well received by the likes of BHP Billiton, Rio Tinto and Xstrata.
Unlike the RSPT, the MRRT will only apply to the mining of iron ore and coal, with the levy reduced to 30 per cent.
BT Investment Management portfolio manager Jim Taylor says the impact of the MRRT, which hasn't passed through parliament yet, will only be modest.
"We're talking in the order of single-digit percentage impacts on the net asset value of those companies based on the most recent version that we have seen," Taylor says.
"Overall we think the actual impact on those larger companies is actually quite modest and even when you look at the cost of production for those companies versus current selling prices for iron ore, the cost of production is around US$30-50 a tonne versus current selling prices of north of US$150 a tonne.
"These companies are making a tremendous amount of money from these commodities. At the moment we are right in the sweet spot so you would expect that they would pay a significant amount of tax during that period, but based on longer-term average prices the companies would assume obviously the amount of tax they pay would be much more modest."
He says one of his preferred picks in the sector is Rio Tinto Group as the company is attractively valued.
"We quite like the outlook for iron ore and coal at the moment and even the prospects for aluminum seem to be improving," he says.
He says Rio Tinto is generating enormous amounts of free cash flow as it is selling its iron ore for US$150 a tonne, with a production cost around US$30-40 a tonne.
"We would expect the company to announce capital management programs and institute buybacks to absorb some of that excess cash flow and on all our measures the stock looks to represent very good value around here," he says. Rio Tinto is also one of Above The Index Asset Management's (ATIAM) most relatively attractive companies.
"Our work shows us that based on the commodity price expectations out there it still looks cheap. It also looks cheap relative to other choices in the market," ATIAM chief investment officer Simon Burge says.
"There are also other positives for Rio - for instance, it has been raining heavily in South America and so its major competitor, Vale, has not been getting as much iron ore out.
"The other thing is that India in recent days has talked about potentially stopping exports of iron ore because they are big users of the commodity themselves."
SG Hiscock & Company portfolio manager Robert Hook agrees Rio Tinto is very attractive, even more so than its larger rival BHP Billiton.
"We prefer Rio Tinto over BHP at the moment as we think the strength in the iron ore prices will continue and this is the major source of their income," Hook says.
"Iron ore is one of Rio's big strengths, but in addition has copper, coal and aluminum, all of which are doing well at the moment.
"BHP has a more balanced mix of copper, oil and iron ore but the ramp up in iron ore production has been slower and the failure of the Potash takeover was a negative. We also prefer Rio's relative valuation to BHP's."
Hook also likes Oil Search.
"To get our exposure to oil we have taken a position in Oil Search. That company's announced that two trains now will go ahead and supply gas and it's in the process of getting a potential third train on the way," he says.
While the managers have noted that bulk commodities is one of their key themes, Rocks argues energy could deliver superior rewards.
"We are much more comfortable taking exposure to energy stocks as opposed to stocks with predominantly bulk commodities," he says.
"If you look at the energy intensity you can see China's energy intensity is very, very low by the standards of the developed world, so it has much more further to go.
"We think that steel intensity is not as strong. Even BHP are expecting growth of 2-5 per cent over the next 10-20 years in steel intensity and we think the upside to energy is much, much higher."
Opportunities abound in industrials
Fund managers believe there are several strong opportunities within industrials, including mining services stocks and specific companies with solid structural growth drivers behind them.
"If you travel around west Australia or eastern Australia there are a vast amount of projects which are really now starting to kick in and will be carrying on for many years to come," Hook says.
Two of his industrials picks are Ausdrill and WorleyParsons.
He says Ausdrill has solid long-term contracts, a good customer suite and is also growing in areas such as West Africa, where there is significant mining-related activity.
Although WorleyParsons looks expensive currently, he says he believes the company will benefit from a marginally weaker Australian dollar and all the mining and oil-related projects taking place. "You only have got to look at some of the contracts they have picked up recently for an idea of how much activity is happening in this sector," he says.
"We are not buying this for 2011 but more for 2012 and beyond."
Fidelity's Taylor says he has an overweight on the industrials sector due to key positions in mining services groups, engineering firms and specific structural growth companies such as private airport owner Map Airports and employment website operator Seek.
"[This year] should be not only a strong demand year for these companies and sub-sectors, but they should also be able to achieve quite strong pricing power through the year," he says.
"Mining services and engineering firms should benefit from the very significant investment planned in major resource and infrastructure projects.
"This strong demand should lead to an improvement in contract terms like a move to a cost-plus basis and higher charge-out rates."
Pace says he's finding specific opportunities, including global packaging company Amcor and toll roads operator Transurban. "We like Amcor because it made a great acquisition at the height of the global financial crisis," he says.
"It bought Alcan Packaging, which was the next biggest player in the European flexibles market. They bought that off a distressed Rio Tinto at the time and paid 5-5.5 times EBITDA (earnings before interest, taxes, depreciation and amortisation) and there is significant synergy to be had over a two-to-three-year period.
"So what they have basically done is transformed the European flexibles market by taking out the next biggest player."
He says Amcor is now four times bigger than its next largest rival and is competing with a number of cash-conscious private equity-owned or private companies.
"Amcor is better managed than it has ever been and it operates in an industry that structurally has never been in better shape and we continue to expect an ongoing re-rating of Amcor as an investment proposition," he says.
He says Transurban pays a yield of around 4.5-5 per cent and has strong potential earnings growth. "What I really like about this one is that it has potential earnings growth of 10-15 per cent out to 2015," he says.
"Its growth is underwritten by moderately improving traffic volumes - so we are talking about 1.5-2 per cent growth in traffic and mandated consumer price index plus toll increases and keeping costs flat over the next three years."
New reality for banks prompts caution
After an impressive recovery from March 2009 to April 2010, the share prices of the major Australian lenders have fallen and stagnated amid concerns over high wholesale funding costs, slowing credit growth and importantly the new Basel III global bank rules. The rules, still under development, will essentially require financial institutions to hold more cash on hand, particularly during good times.
The factors combined have made managers cautious on the outlook for the earnings and dividend growth potential of the major banks.
"You have seen a step down in credit growth in Australia from the mid-to-high teens to the mid-to-high single-digit levels," AMP Capital Investors head of Australian equities Greg Barnes says.
"There is a number of international structural changes going on driven by Basel III and a number of significant changes that have flowed on from the GFC that will have an effect on the banks.
"The banks are great companies, tremendously well managed and a strong industry in Australia and they have proven their capacity by their performance through the GFC, but there is a period of adaptation that they need to go through as a result of those changes."
Barnes says the banks will need to adjust their growth profiles, cost base and manage their margins as they go through the process. "So it's another area that we think will probably be softer compared to the overall market," he says.
Pace says banks look reasonable value relative to where they have traded in a price/earnings sense over the past decade.
"But the other thing to keep in mind there, and where it makes it a difficult judgment call, is that credit growth over the last decade has been a multiple of gross domestic product," he says.
"We would contend that credit growth over the next 10 years will be a lot harder to come by than what it has last decade. That would imply that banks should be trading at a discount to where they have historically."
He says the Basel III global bank rules will require more capital to come from deposits relative to wholesale funding sources and put upward pressure on the loan-to-deposit ratio for all the major banks.
"ANZ will be better placed to cope with these new regulations as it has access to Asian deposits, and CBA will also be better placed due to its retail deposit dominance," he says.
"Westpac and National Australia Bank will be less well placed."
Hook says it's too early to say how it will affect banks, but in the shorter term it won't be perceived as a positive because it requires banks to strengthen their balance sheets.
"But clearly having a strong banking sector is important in this country, so longer term it should be a positive thing," he says.
Retailers battle the power of online
The retail sector is undoubtedly facing three major headwinds - including already weak sales, the prospect of higher interest rates this year and the one that has caused all the rage in the media: consumers' move to online shopping.
Online retail consumer spending in Australia in 2010 is expected to account for around 5 per cent of total retail sales, with nearly half of that going to offshore shops, according to research by consulting company Frost & Sullivan. It is expected to steadily increase until it catches up to the US and United Kingdom's 10 per cent figure.
The trend has retailers, including Harvey Norman, Myer, David Jones and Target, so worried that last month they decided to launch a campaign to have the goods and services tax (GST) imposed on purchases under $1000 from overseas sites.
"We know that people are increasingly purchasing online offshore and why wouldn't you?" Barnes says.
"As a consumer you are looking for the best value and if the best value is online offshore, then people will do that.
"I think it's very hard for retailers to change people's behaviour. What they need to do is find a way of embracing that and making money out of it."
The factors have led SG Hiscock & Company to have a downbeat outlook on the retailers. "The domestic economy is pretty slow at this stage and people are looking for bargains, so it's kind of an area we're staying well clear of," Hook says.
It's not a question of getting things online for 10 per cent cheaper; it's very often 40-50 per cent, he says.
"So even if they add the GST and import duties on goods bought overseas by Australian consumers, it wouldn't do much and certainly wouldn't stop people from buying online because of the range, choice and they arrive very quickly," he says.
Australian retailers will have to rework their approach and may even take a clip on the margins, he says. To add to the consumer discretionary sector's pain, the Australian Retailers Association expects retailers, including those businesses that may have been affected by the floods, will be hit hard by the federal government's flood tax as consumers tighten their purse strings.
"While the cost of the flood tax will differ from family to family, the idea of a new tax is enough to significantly dampen consumer confidence to spend at a time when retail sales are at depleted levels," association executive director Russell Zimmerman says.
Big names preferred in defensive sector
Like industrials, managers believe there are good opportunities in specific defensive names as they are generally unaffected by rising interest rates.
"In the healthcare sector, I like the industry leaders and/or those benefiting from structural growth themes," Fidelity's Taylor says.
"Healthcare should continue to see strong structural growth and should be relatively unaffected by the rising interest rate environment."
Pace says he likes medical device manufacturer ResMed and biopharmaceutical company CSL.
"We think that CSL's sales and margins will benefit after one of its major competitors had to pull their products from various major markets around the world due to product quality concerns," he says.
However, he is less optimistic on Telstra.
"The stock provides plenty of yield but how sustainable is it? Our strong view is that it isn't sustainable," he says.
"A lot of the structural issues that Telstra has had to deal with over the years have not gone."
Hook says he expects Woolworths and Wesfarmers-owned Coles to perform reasonably well and also favours CSL and Ramsay Healthcare. "We still like Ramsay Healthcare because they have good management, good brownfield operations coming into fruition and they have diversified overseas, so any local legislation impact will affect the company less so than pure domestic operators," he says.
