The general improvement was largely underpinned by a gradual but persistent recovery in fundamentals throughout the year.

While some may argue it is fully priced, we believe it is entirely possible the Australian stock market is in the early stages of a bull run that started in the middle of last year, and is set to continue in 2014 and beyond.

Right now, our view is that the market is primed to reward investors that focus on quality and growth; two of Platypuses core competencies.

This outlook is similar to our market view back in 2004 and there are numerous fundamental and technical indicators supporting our bull market thesis.

Fundamental indicators

Leading fundamental indicators are supportive of Australian equities, including low interest rates and an improving property market—both of which have a positive wealth effect.

Low interest rates are unambiguously positive for the Australian equity market. Accommodative rates are expected to remain for some time, with the Reserve Bank of Australia (RBA) looking for the interest-rate sensitive segments of the market to take up the slack from the end of the mining investment boom.

While the RBA may move its rhetoric from an easing bias to a neutral bias over 2014, it is unlikely to start raising rates until there is a substantial pick-up in employment or a significant inflation pulse threatens the broad economy. In general, we expect rates will remain below normal long run levels for some time. At present values, the cash rate represents poor value compared to the dividend that equities provide.

The weakening currency is also providing a tail wind to the economy, as a weaker Australian dollar acts as a quasi-easing monetary policy. A sustained lift in global growth, especially driven out of the US, will continue to put downward pressure on the Australian dollar, significantly boosting domestic competitiveness and export earnings.

The initial benefits of a low cash rate and lending costs are also starting to be observed in the housing market. An improvement in the housing market is often the first stage of a recovery process. Although investors have primarily driven recent price movements, Chart 1 shows building approvals are up, which will improve supply. All in all, we believe the risks of property prices dropping substantially in the short term are low, mitigating the negative flow-on effects to equities.

Consumer confidence is another leading indicator for equity market performance. As shown in Chart 2, consumer confidence has continued to trend upwards and personal balance sheets have been meaningfully repaired since the GFC. Growth in retail turnover improved over the last half of the calendar year (Chart 3), and the January 2014 retail sales number confirmed the continuation of this trend, rising by 1.2 percent.

Technical indicators

There are several technical indicators that also support our bull market thesis. The most obvious is the recent flurry of Initial Public Offerings (IPOs).

A total of 49 companies listed on the ASX in 2013, compared to 46 in 2012. While the number of additional IPOs was slight, and even down on 2011, the amount raised from these new listings was just over $8.5 billion, compared to an average of $2.3 billion for the past five years¹. The issuance was also diverse by sector, suggesting broader market strength.

Firms prefer to issue new equity during bull markets, as there is a greater chance of being successful and valuations tend to be higher. 2014 has started with a strong pipeline of IPOs which is expected to continue throughout the year.

An increase in IPO activity is often a precursor to merger and acquisition (M&A) activity. Early M&A signs were present in 2013, including the examples of Wesfarmers’ sale of its insurance business to IAG and Westpac’s purchase of Lloyds’ Australian operations. As the bull market gains momentum, we expect M&A activity to pick up.

As Chart 4 shows, until six months ago the market had been caught in a four-year technical trading range. The recent break-out is positive, but will need to be supported by increased volume and improved earnings expectations to be the start of something bigger.

While volumes are still modest, there is mounting evidence the market is beginning to pay for earnings growth.

Chart 5 shows the relative value of high growth names versus low growth names. Since mid-2013, the market has begun to pay more for high growth names. Given the strong fundamental outlook, we expect the market will continue to pay for growth—however, this growth will need to be supported by robust earnings so it will be important to be positioned in high-quality, growth names.

Return expectations

The strong return from the Australian equities market over the past year leads to the question: if the improved fundamentals of low interest rates, a low currency, and an improved building cycle will support Australian equities in 2014, how much is already priced in?

Two data points lead us to believe Australian equities present good value for investors. The first is the market yield compared to the cash rate (Chart 6), and the second is the improvement in company earnings.

Yield stocks have done very well in 2013, but indiscriminately owning the market as a whole still gives investors a better yield than cash. From a long-term perspective, an investor is being paid to hold equities at these levels.

With market yields continuing to be attractive when compared to the prevailing cash rate, we believe the yield trade still has some time to run, particularly thanks to the additional benefit of franking imputation credits.

In addition, company earnings are steadily improving without large valuation expansion.

The average forward price-to-earnings ratio (P/E) of the market since the early 1990s is 14.4 times, and at 28 February 2014 the market was trading on 14.5 times. This is not expensive by any means, especially in context of the current expected earnings environment. As shown in Chart 7, company earnings have been improving without strong valuation expansion.

The recent reporting season saw the market move from a little over 5100 to just over 5400 in a three-week period, taking many bears by surprise.

While pauses, such as that experienced in January 2014, are a part of any healthy bull market, the structure of the pullback was still supportive of our thesis. The correction was led by larger capitalisation stocks, with sentiment holding up for smaller capitalisation names. This implies investors were happy to hold smaller stocks in the lead-up to reporting season, demonstrating some comfort in expectations.

Chart 8 shows, following the recent reporting season, forward earnings estimates for the market have continued to grind higher. While the improvement in earnings expectations still appears modest in absolute terms, the relative turnaround in expectations shows a marked improvement.

Our view is that forward earnings conditions are improving and the market will likely grow earnings by low double digits in FY2014. This is a reflection of the positive macro environment for company earnings, particularly the double impact of a lower currency and low interest rates.

We have been here before

The long-term investment capability of Platypus Asset Management has been proven across varying market conditions. However, the purple patch for our process is during quality-led bull markets.

It is our strong belief that the current market environment is primed to reward investors that focus on quality and growth, two of Platypus’ core competencies. Our portfolio is well positioned to take advantage of a bull market, and importantly, we have a proven capability of delivering in these market conditions.

By Donald Williams, Chief Investment Officer, Platypus Asset Management  

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¹      PO Watch, The market for emerging companies, January 2014, HLB Mann Judd Australasian Associates.

²      As at 27 February 2014. Flagship portfolio is the Platypus Australian Equities Fund. Returns are calculated before fees and expenses. Past performance is not a reliable indicator of future performance. Alpha/outperformance is a measure of performance on a risk-adjusted basis. Alpha/outperformance takes the volatility (price risk) of a fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha/outperformance.

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Chad Padowitz

Australian Unity Investments’ equities fund manager partners agree that while the overall outlook for markets – both domestically and internationally – looks positive, investors need to be selective.

Chad Padowitz, chief investment officer at global equities manager Wingate Asset Management, said 2014 will be a more challenging year than 2013 for investors, although there are still good opportunities around.

“There was a bit of investor complacency in 2013, as the lack of alternative investment options and low volatility enticed investors back into the equities market. Yields have been attractive and valuations have largely been an afterthought.

“This year, investors will need to pay more attention to valuations in order to pick the best opportunities.

“There will also be significant differences in how various economies perform in 2014. For instance, the US is looking very strong, with an improving labour market, oil/shale revolution, manufacturing renaissance and strengthening housing markets. However Europe is treading water, and China is making the difficult transition from investment to consumption, and may experience a credit crisis.”

Mr Padowitz said in addition to the energy sector and selected cashed up corporates, some of the best opportunities for international equities are likely to lie in healthcare, where investors can benefit from improving efficiencies.

Mr Padowitz added that the introduction of “Obamacare” in the US will create both winners and losers for investors.

“Companies with scale and low costs – such as large insurance companies and service providers – will benefit from Obamacare, while those with high profit margins and minimal product differentiation will find the new environment much more challenging. This includes hospitals and medical professionals.

Donald Williams, chief investment officer at Australian equities manager Platypus Asset Management, agreed with the opportunities in healthcare and said there are also a number of positive signs for the domestic market.

“We are now seeing the lagged impact of low domestic interest rates, which are starting to have the effect the RBA was looking for, and the declining Australian dollar is generally positive for earnings.

“Consumers are more optimistic; the property market is improving, resulting in a wider wealth effect among Australians; and the IPO market is back which is often a precursor to M&A activity.

“All these indicators lead us to be reasonably bullish for Australian equities, though the February reporting season could be tough, reflecting the ongoing weakness in the economy last year.” Mr Williams said.

In the Australian healthcare sector, Mr Williams said that there are a number of positives for companies such as Resmed, Ramsay Healthcare, Healthscope and CSL.

“The falling Australian dollar combined with the defensive earnings profile of companies such as Ramsay, Virtus, Resmed and CSL suggest a good outlook for such companies.

“We also anticipate a number of healthcare IPOs in 2014 which will create good opportunities for investors.”

Mr Williams added investors will need to pick and choose where to put their money very carefully.

Chris Smith, head of healthcare and retirement property at Australian Unity Investments, said like the rest of the world, growth in healthcare property and services in Australia is pretty much guaranteed because of the aging population.

“Our aging population and greater longevity, combined with generally increasing prosperity, will lead to greater demand for healthcare, both facilities and services.

“Both the government and the private sector will need to step in to meet this demand over the next few decades,” Mr Smith said.

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Australian equities manager Platypus Asset Management; international equities manager Wingate Asset Management; and fixed interest manager Altius Asset Management all agree that the economic, investment and financial world has continued to change over the past seven years and many rules that previously held true will need to be reassessed if investors are to see positive returns this year.

Mr Donald Williams, chief investment officer at Platypus, said that since the global financial crisis there has been a number of further shocks, including the current European debt crisis but he believes things are now beginning to look better for equity investors.

“The second half of 2011 was a very difficult time for equity investors. However, 2012 has already shown more positive signs.

“The data from the US is upbeat and we are about as certain as we can be that there will be no ‘double-dip’ recession.

“China’s inflation appears under control and while the problems in Europe remain serious, it seems governments there are at last treating the issues with the urgency they need.

“At home, we think the Australian dollar (AUD) will remain uncomfortably high this year, and in the short term it could make new highs against the US dollar (USD), as it has already done against the Euro.

“This will continue to affect a number of industries directly and make USD/Euro revenue earners less attractive. The only positive to come from this is that the Reserve Bank of Australia (RBA) is likely to be more aggressive on rates to keep a lid on the AUD. Most of last year they were cheering on the AUD strength – now it is a policy problem.

“However, the RBA has done the right thing by cutting interest rates at the end of last year, and overall we believe the Australian economy is in a solid position.

“Our view is that the Australian market will stay relatively subdued for the next six months while overseas issues play out and Australian investors achieve a level of comfort with what is happening there.

“After that, and assuming there are no more major shocks to the system, we believe the market could end the year having overcome the 5000 point milestone,” Mr Williams said.

Mr Chad Padowitz, chief investment officer at Wingate, agrees investors now need to take a new look at investment options and approaches they may previously have disregarded.

“It can be easy for Australian investors to dismiss international equities as too risky, too exposed to the downturn in the US and Europe, and look to the past 10 years’ subdued performance as justification.

“Certainly there are some serious adverse overseas considerations that must be taken into account. Global deleveraging is continuing – as it should, with debt having been built up for over 50 years in most developed countries that now needs to be repaid.

“Additionally, the risks from Europe have the potential to create a ripple effect around the world, in the same way the Lehman collapse did. Another failure by a major organisation such as a bank, or a major shift to the hard left – or for that matter extreme right – in politics could create global problems.

“But at the same time, many top tier global companies have good earnings and strong balance sheets, despite the difficult economic environment. Therefore they should be very attractive to investors, particularly because of the yield being offered on current prices.

“On top of this, many companies are buying back their own shares as opposed to over-investing in potential future growth, which by itself will create better returns for investors in those companies. Home improvement retailer Lowes is a good example of this,” Mr Padowitz said.

Mr Chris Dickman, senior portfolio manager at Altius, said bond markets are also an example of how many of the traditional axioms of investment markets no longer hold true.

“The exceptional level of interest in Australian bond markets by international investors and central banks surprised many investors in 2011, who did not expect our market to perform as well as it did.

“We believe this interest from off-shore investors will continue in 2012. The Fed has announced it will be keeping US rates at very low levels for the next couple of years. In this light, Australia continues to offer high yields compared to other developed economies, which will act as a magnet for ‘carry trades’.

“This is in addition to the benefits of being seen as a safe haven, having a relatively strong economy, one of a diminishing number of AAA-rated, and a hedge against the risk of a Chinese slow-down,” Mr Dickman said.

Altius also believes 2012 will see some positive activity in bond market issues added Mr Dickman. “Globally there is something of a log jam of issuers who have been waiting for the ‘right’ time to issue but at some point during the year they will simply have to push the button.

“The success of the Commonwealth Bank’s covered bond issuance, followed quickly by Westpac’s, demonstrates the appetite among investors for different types of funding. We think it is likely that corporates, who would usually have used bank loans for financing, will instead consider corporate bonds. This brings corporate bonds to the fore,” Mr Dickman said.

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