Sentiment towards equities is quite interesting. Very few investors seem bullish, some seem complacent, and many seem quite cautious. On the latter, we note many other fund managers are holding relatively high levels of cash within their equity funds. Market levels will reflect investor sentiment, and so this point is a positive.
Currently, the Australian market trades on reasonable valuation metrics.
As at 30 June 2017, it trades on:
- a PE multiple of 15.8x the next 12 months consensus earnings, which equates to an earnings yield of approximately 6.3%;
- a dividend yield of 4.5%. This implies that only about 70% of earnings are paid out as dividends on average, leaving the remaining 30% to be reinvested back into businesses for future growth. This dividend yield of 4.5% also comes with a level of franking credits. On a grossed up basis, which is the best measure when comparing the yields available on bonds and like assets, this yield equates to 5.9%; and
- EPS growth of approximately 8% for over the next 12 months. As discussed below, there is significant earnings risk within the Australian market, meaning that this growth forecast is likely to be revised down. That said, there is likely to be at least some level of growth that augments the dividend yield. This earnings growth partly results from the reinvestment of retained earnings.
A major risk in the Australian stock market is earnings risk. This is the risk that companies miss the market’s expectations of earnings. Based on our many company meetings and extensive industry contact, we believe many corporates are doing it tougher than appreciated by the market. This might well play out during earnings season in August. If we are right, it means the ‘E’ assumed in the P/E ratio is currently too high, and that in reality the PE is actually higher.
Even allowing for this risk, Australian equities continue to look relatively attractive, especially in the context of low prospective returns for other asset classes. For example, cash, which as before is attracting a number of fund managers, pays less than 3%.
The attraction of equities very much depends on where interest rates go from here. Current valuations can afford some moderate rise in rates, but probably nothing too dramatic. On this, we are quite calm. The recent uncertainty around rates has however introduced some volatility to the market. It is resulting in something of a tug-o-war between the reflation trade (supporting cyclicals, value stocks and inflationary beneficiaries such as banks) and the duration trade (supporting yield plays and long-duration growth stories). These macro issues tend to work themselves out over time, with stock returns ultimately determined by company fundamentals.
