Reporting season expected to shift investors to equities from bonds


Independent Australian investment management company, Dalton Nicol Reid said the recent strong reporting season should intensify the current shift in asset allocation seen among professional investors.

Chief Investment Officer, Jamie Nicol, said even with recent market volatility, he expects asset allocations to continue to swing away from bonds towards equities.  He warned however, that a focus on quality is necessary to distinguish between those equities that have genuine operating upside as the cycle turns, as opposed to a simple short covering rally. 

“Given risks now seem to be easing and interest rates are low, we expect flows to be supportive of equities.  Additionally, any pullback in the market is likely to be well supported by the amount of money sitting on the sidelines,” Mr Nicol said.

“The last few days we have seen a selloff in growth companies that missed their results expectations and I think this signals we will see a little more dispersion in performance rather than the rising tide lifting all boats that we have enjoyed of late.  However, this also delivers opportunity.”

Mr Nicol said relative to bond yields, equities looks attractive when compared with either the PE of the market or dividend yields. 

“The market is trading at 13.8 times PE, which looks about average and not particularly cheap on an absolute basis (although not expensive either).   However once we compare the market to low interest rates, which look like they are here to stay, the story is very different. In particular, we note that the dividend yields available from companies are in many cases already twice the yield available from bonds and the dividend yield should be growing.”

“Over the last few years investors valued the security of bonds regardless of price. As the risks fade, then the value of holding a bond earning less than half the amount available from equities begins to look questionable,” he said. 

“Investors should also consider the potential of another bond crisis, like the early 90’s, should inflation spike in the US.”
In terms of the recent reporting season, Mr Nicol said growth companies, which have enjoyed a strong run, are starting to be sold off where the results did not meet expectations. 

“In some instances we have seen the global growth pick up yet to come through (Ansell); in others we are seeing a simple miss as the businesses mature (Cochlear); and in others, stock specific disappointment (Breville).  Interestingly Healthcare has had a difficult reporting season.  This is a reflection of Governments pulling back spending from the sector and the recent strong run.”

Mr Nicol said there are definitely signs of a pick up in housing and to a lesser extent, media and retail. “In some instances, this has triggered a short covering rally.  For example, we are reluctant to buy JB Hi Fi, given they continue to face structural threats.  Sales of CD’s, DVD’s and games are shrinking as consumers purchase on-line.  The main categories that are growing (Ipads and other tablets) offer lower margins.

“We are seeing a range of companies lift earnings including leaders such as the banks and Wesfarmers.   This is providing a further kick along for these companies, although in my mind, it really just justifies the rally to date.” 

Mr Nicol said good results from CBA and Bendigo highlight the easing funding conditions for banks, which is driving stronger profits.  

“Expected profit growth for the major banks has been lifted a couple of percent.  Strong capital position increases the likelihood of future buy backs and bad loans are easing as interest rates decline.  This increases market confidence regarding FY14. The trends are particularly favourable for the domestic retail banks, hence the strong moves by CBA and WBC.”

Dalton Nicol Reid uses a five-point quality matrix to identify relative quality of listed companies.  This includes balance sheet assessment, industry structure, management strength, earnings strength and ESG (environmental, social and governance).   Research on quality investing has largely focused on the back testing of various quality screens to determine the impact of quality on returns.  On the whole, this research has shown a strong linkage between quality and performance over the medium and long term.

“A quality portfolio will be agnostic to value or growth.   Following a quality investment approach allows us to identify companies that are mispriced by overlaying this quality filter with a strong valuation discipline.  It also allows us to enhance returns by identifying companies when they are out of favour.”

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