BANKS
The major banks have attractive income yields relative to alternatives of cash, term deposits and investment-grade bonds. Fully franked dividend yields between 5.5% and 6.6% gross up to 7.8– 9.5%. All four major banks are trading close to our fair value estimates. In order of major bank preference, we like Westpac, Commonwealth Bank, National Australia Bank, and ANZ Bank.
INSURANCE
The general insurers are broadly fairly valued with QBE most attractive and Suncorp modestly overvalued. QBE’s management team is turning the business around, and we expect the ongoing transformation and de-risking to deliver more benefits to the balance sheet and earnings quality. IAG is trading close to fair value. NIB Holdings is expensive compared with our valuation. In most cases, fully franked dividend yields between 3.5% and 5.5% grossing up to 5.0–7.9% are attractive. In order of preference, we like QBE, IAG and Suncorp. Insurance broker Steadfast Group provides attractive earnings growth and is trading 19% below our recently upgraded fair value.
DIVERSIFIED FINANCIALS
Platinum is attractively priced and while there are short-term pressures, we expect earnings to recover given its strong brand and long-term investment performance track record. The ability to take short positions provides Platinum with opportunities to outperform in most market conditions. Magellan trades near our fair value estimate but attracts with its offshore equity investment focus using a similar long-term, moat-focused investment philosophy to Morningstar. Despite the near-term pressure on earnings growth, IOOF is well positioned with its vertically integrated business model to benefit from favourable sector dynamics. Challenger is fairly priced compared to our fair value estimate but we like its increasingly popular annuity product offering particularly in a relatively low interest rate environment.
TELECOMMUNICATIONS
Spark New Zealand has already promised a special DPS of NZD 3 cents (in addition to ordinary DPS of NZD 22 cents) in fiscal 2017, equating to a yield of 7.1%. However, we believe more could be flagged in 2017, given the benign New Zealand regulatory backdrop and the fact Spark has come out of its recent capital expenditure hump with an industry-low net debt/EBITDA of 0.8 times. While Telstra does not tick many boxes mentioned above, there is clear valuation support to remain a core holding in any diversified portfolio (6.3% fully franked yield, 17% discount to our AUD 6.00 fair value estimate). NBN risks have been well-communicated and there could be upside risk from a revised capital management framework in 2017. Higher up the risk curve, Vocus Communications has the potential to surpass severely depressed expectations and close the 42% discount gap to our AUD 7.00 fair value estimate. There are various “self-help” avenues (achievement of fiscal 2017 earnings guidance, and progress on synergy realisation from recent acquisitions) for management to prove the good quality of Vocus’ assets and begin the stock re-rating process.
MEDIA
News Corporation is our preferred pick in 2017. It ticks the boxes in terms of cost reduction initiatives and financial strength with USD 1.1 billion net cash. We also believe Move, books and likely Australian dollar weakness will drive near-term earnings growth. Nine Entertainment is attractive, with management aiming to keep costs flat, despite higher investments in premium local content, and the balance sheet in strong shape). We see the current yield of 10.9% as secure in 2017, while the depressed multiples make Nine a vulnerable takeover target if media ownership rules are abolished. Fairfax Media remains our least preferred stock. Not only are the legacy print assets (with earnings still falling) weighing on Domain, but the crown jewel itself is showing signs of slowing. The mere 2% revenue lift in the first four months of fiscal 2017 could be temporary. However, with the stock trading at a 17% premium to our AUD 0.75 fair value estimate, market expectations seem overly optimistic for a rapid recovery in Domain’s growth.
TECHNOLOGY / PROFESSIONAL SERVICES
Our preferred stocks include narrow moat-rated MYOB and Xero which provide high-quality exposure to the fast-growing cloud accounting software segment and currently trade below our fair value estimates. Narrow moat-rated Carsales.com and Link Administration also have strong competitive positions, large market shares, and offer value following recent bond market-related share price weakness. ISentia, and Reckon offer value for higher-risk-tolerant investors as both lack economic moats and have company specific risks which need consideration. Our least preferred stocks include no-moat-rated Cabcharge and SMS Management & Technology which face displacement by new technologies and large overseas competitors.
GAMING
Crown Resorts is our most preferred stock in the sector, trading at an attractive discount to our fair value estimate. The negative sentiment driven by the detention of staff in China continues to weigh on the share price. However, we remain positive on the long-term outlook of Crown’s core Australian properties, namely Melbourne, which is premised on the strength of local gaming and nongaming business. Various strategic initiatives could act as further catalysts. While lacking near-term catalysts, Ainsworth Game Technology remains a long-term opportunity once evidence of a turnaround in Australia emerges. We believe continued expansion in North America and benefits under Novomatic ownership are likely to propel the share price from the current low. Our least preferred stock is The Star Entertainment Group, purely driven by valuation. Despite the healthy near-term earnings outlook, we believe the market is failing to appreciate the impact of new competition in Sydney and execution risks with its major development pipeline. The stock is currently meaningfully overvalued relative to our fair value estimate.
RETAIL / FOOD & BEVERAGE
Our preferred stocks are narrow moat-rated Woolworths and Wesfarmers, trading at around their respective fair value estimates. The least preferred are no-moat-rated Harvey Norman and JB Hi-Fi, both trading at significant premiums to their intrinsic values. We continue to rate investments in Woolworths and Wesfarmers as defensive, given their status as leading Australian large cap stocks in the consumer staples sector. Also, both stocks offer attractive dividend yields. However, we see limited upside to share prices from current levels, as we expect food margins in the Australian supermarket sector to remain under pressure in 2017. Woolworths’ exposure to the supermarket industry is greater than the diversified Wesfarmers and therefore also to the trends affecting the industry. We expect Woolworths and Wesfarmers to pursue the divestment of noncore assets in 2017 (petrol and coal, respectively).
HEALTHCARE
CSL is our most preferred large cap stock. At a 24% discount to our AUD 125.00 fair value estimate, we believe the market is underestimating the impact of the Seqirus vaccine division and underappreciating the value generating potential of its diverse R&D pipeline. ResMed is our second preference given its 22% discount to fair value. The company is a global leader in terms of its product offering and innovation in the sleep apnea space, and is well positioned given its Australian dollar-denominated cost base and U.S. dollar revenue. Ramsay Health Care is also attractive trading at 21% discount to fair value. We think the stock has been oversold following a cautious trading update by domestic peer Healthscope and see concerns over potential regulation of prosthesis pricing as overdone.
TRANSPORT
Despite the mostly negative outlook for earnings, we have a Neutral view of the sector, which trades largely in line with fair value. Qube is our preferred position given its diversification into the Patrick containers business and the green light on Moorebank a potential positive catalyst. We rate management highly and believe the firm is well-placed to build an efficient, vertically integrated logistics company over the long term. Airlines are least preferred on a poor earnings outlook. However, they do trade on low P/E multiples and are considered to be fairly valued.
UTILITIES
Spark Infrastructure and AusNet Services are preferred picks in the utilities sector given regulatory risk has already played out and they are mostly protected from rising interest rates. Both offer 6%-plus yields with modest growth and sound balance sheets. We also like the New Zealand dual-listed “gentailers”, particularly Mercury NZ with its 100% low cost North Island hydro and geothermal generation. AGL Energy is overvalued on a longer-term view, with potential risks including closure of aluminium smelters, rule changes to limit market power and new renewable generation supply. The Cheung Kong bid for Duet Group shows ongoing global demand for low-risk Australian assets, particularly for majority stakes and where share registers are open.
INFRASTRUCTURE
We hold a neutral sector view as stocks trade around fair value. With the highest financial leverage, Transurban’s security price may be hit hardest as the market factors in rising bond yield but this may create buying opportunities later in the year. Longer debt maturities and hedging should mean Transurban’s interest expense rises only gradually near term. We also like Auckland Airport and Sydney Airport give n good passenger growth outlook and strong competitive advantage, and would likely recommend these names should process fall further. Macquarie Atlas is least preferred given weaker earnings growth, shorter concession life and a risk that free cash flow growth upon debit refinancing is less than expected.
BUILDING MATERIALS
We have a negative view of the sector given a forecast decline in Australian and New Zealand construction with the sector generally trading at material premiums to fair value estimates. Dulux is the exception trading at 0.9 times fair value and is our most preferred exposure. Fletcher Building is least preferred with the stock trading at 1.3 times fair value and New Zealand construction near the peak. James Hardie should continue to trade at a material premium to fair value near term given the strength of the U.S. housing recovery and a potentially weaker Australian dollar, but longer term is expected to revert to our fair value estimate.
PAPER & PACKAGING & OTHER INDUSTRIALS
We consider the Paper & Packaging sector to be overvalued, trading at a 20%-30% premium to our fair value estimates. We have Reduce recommendations on Orora, Pact and Amcor with their current share prices, in our view, inflated by the expectations of more aggressive U.S. volume growth. Brambles is trading broadly in line with our fair value estimate. We believe investors are correctly balancing future growth stemming from higher U.S. inventory levels, partially offset by capital expenditure requirements to continue lifting pallet service levels.
PROPERTY / REIT’s
We see the most value in subsectors with robust demand fundamentals and where there has been discipline in adding new supply. We see the most attractive property stocks as Goodman Group, Westfield Corporation, and Aveo Group. Industrial developer and manager Goodman Group continues to benefit from strong demand for its strategically important sites, with occupancy and rent growth expected to exceed smaller peers. We forecast development volumes to remain robust, with new stock feeding a funds management platform generating stable and low risk earnings. Westfield’s redeployment of capital to major international cities further aligns its shopping centre portfolio with the high income demographic whose retail spending we believe is relatively insensitive to economic cycles. We also anticipate value creation from the development of apartments on many of its major inner city locations. An ageing population and rising healthcare requirements means Aveo stands to benefit from very strong organic demand in the future. We forecast significant earnings growth from its development pipeline and the integration of aged care services across its portfolio. Least preferred are firms developing apartments, including Mirvac and Lend Lease.
METALS & MINING
With the bounce back in commodity and share prices, we think the sector is generally overvalued. Iluka, Newcrest, New Hope and Mount Gibson are at the largest discounts to our fair value estimates, while Whitehaven, Fortescue, and Mineral Resources are all substantial premiums.
OIL & GAS / ENERGY
Refiner/retailers Caltex and Z Energy trade at close to fair value after recent approximately 20% share price pull-backs. Further weakness could present opportunities with Caltex benefiting from the ownership of pipeline and other moaty infrastructure, while Z Energy has dominant New Zealand market share. Santos is the cheaper of the two largest local LNG-focused E&Ps, with a price/fair value, or P/FV, of 0.8 to Woodside’s 0.9. They are of similar calibre, though Santos comes with somewhat elevated net debt. We don’t anticipate either company to expand near term, the focus instead on operating existing assets to maximum efficiency. At the small end, we see compelling value in AWE with P/FV of 0.6, while Beach Energy is overvalued. Both are very high uncertainty-rated. A runaway oil price isn’t necessary to fuel outsize leverage from the minnows. Woodside and Santos are relatively lower risk bets.
MINING SERVICES
We derive a sector price/fair value of 1.3, with all companies trading at some premium. Least overvalued is global explosives provider Orica Limited at 1.1. Most overvalued are materials tester ALS Limited at 1.7, and oil and gas engineering services provider WorleyParsons at 1.6. Price-agnostic preference is for CIMIC group which demonstrates highest cash returns on invested capital and is closest to earning a moat in a no-moat sector. Orica earns an honourable mention with its Australian duopoly and U.S. oligopoly commercial explosives businesses. Least preferred are Downer and ALS Limited given sub-5% forecast cash ROICs.
