Why the Australian stock market is now back to fair value

Wednesday, June 10th, 2015

With the market correcting back below 5,500, now is the time for investors to steel themselves and act differently from everyone else. That means looking for opportunities to buy.

This stock market correction is painful for investors, but we think the market is now trading below fair value and throwing up opportunities.

The good news is that if investors have been following what we’ve been saying for the past five months — that there hasn’t been much value in the market – they should have cash available to buy.

There are currently five major stocks we particularly like in this correction that are showing good value.

More than eight years of low returns

After hitting highs in April, the Australian share market has fallen back around eight per cent to below 5,500.

We think that’s interesting from a short and long-term perspective.

Figure 1. All Ords

Figure 1. All Ords Index
Source: Thomson Reuters Datastream

The market has now dropped to levels seen last July – so investors haven’t had capital gains in eleven months.

But at 5,500, the market is also back to where it was in December 2006: so effectively index investors haven’t earned capital gains for 8.5 years.

If an investor held the index (as many experts claim they should), over that period they earned the equivalent of a term deposit, but with huge risk. (In the midst of the GFC, by February 2009, shares had more than halved from their peak of 6800 in October 2007.)

But what is extraordinary is that over the past 8.5 year period Australia’s population grew by two million people; our gross GDP surged 35 per cent; the economy benefited from the biggest resources boom seen in its history; and the Government ran successive deficits totalling $300 billion, which would normally stimulate the economy. Interest rates and bond yields also fell to historic lows.

So why weren’t stock market returns higher?

In retrospect, when the market was at 5,500 in December 2006 it was fairly valued; but at 6800 in October 2007 it was highly overvalued.

The other reason for the lacklustre performance has been corporate profitability. Yes, profits as reported by companies have increased by more than 35 per cent over the last eight and a half years, but return on equity (ROE) is at recession-type levels. So while making record profits as a group, Australian corporates are operating at record low profitability as measured by ROE.

Is the market fair value today?

But based on our ROE modelling, we believe the market has now fallen to slightly below fair value on a required return of 10 per cent (or 7 per cent greater than the Australian bond yield).

We think the market today is probably already discounting bad news. The worst news for the market would be an increasing $A. We think a currency of $US80c is priced into the market today. The market is not priced for an $A fall; so if the currency declines toward $US70c the market will perform relatively well.

But if the dollar rallies to the mid-$US80c, that will slow Australian growth and the market will be very fully valued.

Five opportunities

Given the market is now below fair value, we believe investors should be selectively picking up high quality Australian stocks. Our preferred stocks include NAB following its capital raising. We also like Telstra below $6, cum dividend; Woolworths is an accumulate at around $27; and Wesfarmers, given its forecast yield of 5 per cent, is an opportunity at about $40. A weakening $A also makes CSL attractive as a proxy for offshore investing in a high class company.

All these companies should deliver investors a return of about 10 per cent in the coming year from a solid dividend and steady earnings growth.

 

Disclosure: Clime owns shares in CSL Limited, National Australia Bank, Telstra, Wesfarmers and Woolworths

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