Four assumptions the market has wrong

Markets can be prone to overconfidence at times, and when these ‘certainties’ don’t come to pass the results catch investors off guard. In 2011, markets had priced in never ending growth in Chinese demand for Australian commodities. By the time 2015 rolled around, those investors who had bought into this story were suffering the consequences. Avoiding buying into these popular delusions can go a long way in avoiding the big mistakes. In this edition of Buy Side Brief, we asked some of our regular contributors where they see such overconfidence in prices in today’s markets. Responses come from Chris Prunty, Justin Braitling, Simon Bonouvrie and Matt Haupt.
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Small Resources will not recover in 2016

Chris Prunty, Co-Portfolio Manager - Microcap, Ausbil


My colleague and I fancy ourselves as small cap specialists, so one of the interesting features of the market over the past year has been the attempt of small cap resources to get off the floor.  The Small Resources Index rallied over 10% 3 times in 2015; in February, April, and October.  The argument goes that after falling -32% in 2011, -19% in 2012, -42% in 2013, -28% in 2014 and -17% so far this calendar year, small resources are “due” for a bounce.  We are not so sure.  The inability of small resources to make a sustained rally is not a surprise.  History tells us that commodity prices tend to have very long cycles. The Small Resource Index rose 625% between 1999 and 2010.  It has now fallen -81% since 2010.  Despite this, the long-dated nature of commodity cycles and some stretched balance sheets mean it’s hard to get excited about the prospects for the small resource space in aggregate.  I’d caution against the belief that because something is down -80% it has to represent value.


Blue chips won’t see further dividend growth

Justin Braitling, Chief Investment Officer, Watermark Funds Management


As interest rates have fallen, forcing investors to look for yield in risk assets, income has been re-rated versus growth. We believe this re-rating of income generating assets has run its course. Low growth, mature share markets like ours are looking expensive relative to others with stronger growth prospects. You can see this from the recent underperformance of the ‘magnificent seven’ leaders: the banks, Woolworths, Wesfarmers, and Telstra. Having led the bull market since the GFC, they now appear to have rolled over. The companies have responded to these pressures by pushing up payout ratios and returning more earnings to shareholders. Investors should consider the growth they can expect in dividends from here, in many cases the dividends might be at risk. One bank, in particular, is prepaying tax to frank its dividends; this is also unsustainable. The sustainability of dividends is clearly a question all investors should be examining closes. Some companies are paying out too much and re-investing too little.


No major uptick in bad debts for the big banks

Simon Bonouvrie, Portfolio Manager, Cadence Capital


The market is pricing in a recession scenario for the Australian Banks. The sector is pricing in a ramp-up of bad debts over the next couple of years, however, we think the Australian economy is proving more resilient than many people think and the bad debt experience for the banks will be benign. We have just had two strong months of domestic employment data and the unemployment rate has fallen back to 5.8%. Inflation is low and GDP growth is reasonable despite the mining sector headwinds, helped in part by the decline of the AUD. The low cash rate at 2.00% is assisting households and businesses service their debt obligations and there is scope for the RBA to implement further rate cuts if required. Bank sector valuations are screening cheap versus the broader industrials market and also cheap relative to their own valuation history (on a P/E basis). Bank dividend yields are cheap versus the RBA cash rate and term deposit rates. In a recession scenario, bank earnings and dividends would come under pressure, however, we believe a recession is unlikely to occur in the foreseeable future. Within the sector, bank P/Es are trading in a wide range (between 10 – 14x earnings) reflecting some company specific earnings risk for the cheaper banks (e.g. Asian exposure risk for ANZ Bank). The mortgage-focused banks such as Westpac, Commonwealth Bank and Bank of Queensland look good at the moment with P/Es that are attractive combined with a favorable business mix.


Oil price to recover in the second half of 2016

Matt Haupt, Equity Analyst, Wilson Asset Management


The market is pricing in low oil prices into the foreseeable future, however, I expect to see a price increase in the second half of next calendar year as inventories clear. The oil price has fallen from well over $100 a barrel 18 months ago to be trading below $40 currently. The current low oil price is a reflection of a strong US Dollar and OPEC members trying to hold onto market share in an oversupplied market. Production has consistently run higher than consumption for over the past two years; the recent data we are seeing demonstrates production and consumption have finally converged. If this trend continues we will see the current record inventory levels start to decrease over the next few months and a strengthening oil price to ensue.

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