Reflecting on the importance of your asset manager being unconstrained

Market insights

Brian Sparkes, Investment Specialist, Macquarie Australian Equities
Monday 30 January 2017

The Australian equity market performed strongly through 2016, with the ASX200 finishing up a healthy 11.8% on a total return basis, and the Small Ords finishing up higher at 13.2%.

This strong performance however masked a year that was divided into two halves. The first six months of 2016 saw the ASX200 up only 0.6% (including dividends), while the second half of the year saw more fruitful gains for investors with the ASX200 returning 10.6% for the six months to December 2016.


Style rotation – from growth to value

The divergent half-year performance was also marked by significant style rotation. As can be seen in chart one below, from February 2016 we saw a rotation in stock leadership away from quality growth companies, and into value. This rotation posed a challenge for asset managers that have an investment philosophy that leads them to invest in a particular type of company. As you will have heard us say many times before, being unconstrained is, in our view, the best way to deliver sustainable returns above the benchmark over time.

Cumulative Outperformance versus the Market

Source: Macquarie Securities

Past performance is not a reliable indicator of future performance.


2016's key value opportunities

A number of key value names came from the much maligned resource sector. Commodity prices, most notably coal and iron ore, rallied through the second half of 2016 with iron ore rising from ~$US55 in October to more than $US80 by year end. Coal skyrocketed, with hard coking coal rallying from $US80 to $US300 following supply side reform in China.

These strong commodity prices had significant impacts on resource companies leveraged to the rising prices. Fortescue Metals rose more than four times from $1.50 to almost $7. South32 rose more than three times, while Whitehaven Coal climbed almost eight times from $0.40 to ~$3.20.

Rising price of iron ore and Fortescue Metals Group

Rising price of coal, South32 and Whitehaven Coal

Source: Macquarie

Past performance is not a reliable indicator of future performance.


There were also value opportunities across a range of sectors, including many of the names with significant short interest (i.e., shares that many investors took short positions in).  Metcash, Australia’s third largest supermarket retailer, delivered an earnings result above market expectations as its turnaround continued to gain momentum throughout the year. Cleanaway Waste Management, one of Australia’s largest waste management firms, rose 55% after delivering a solid FY16 earnings result that also beat market expectations.


The overvalued underperformers

Conversely, companies trading on significant premiums to the market that missed on expectations were punished, often severely. Healthcare names struggled, with aged care providers Regis Healthcare, Japara Healthcare, and Estia falling 21.6%, 29.4% and 62.2% respectively. Private healthcare operator Healthscope also struggled falling 13.9% in the year. Online retailers, and prior market darlings, struggled, with online firms Seek and Carsales.com falling 3.3% and 2.8% respectively in the year. 


The overvalued underperformers

Within the Australian equity market we believe the best performers will be found through disciplined stock selection. Our research is leading us to hold overweight positions in offshore earners, as well as Australian industrial companies with limited cyclicality in their earnings.

Commodity prices, particularly those that rallied strongly in the latter half of 2016, will likely soften. We expect energy to be a bright spot, with the ongoing evolution in supply dynamics driven by OPEC likely to push prices higher. Australian electricity markets are also likely to be one area to watch, with prices set to trend higher as rising demand and falling supply hits the eastern states.

Yield stocks are likely to see continued pressure as international interest rates begin to rise. Being selective, and focusing on those companies that are able to sustainably grow earnings and cashflow and are willing to distribute dividends to investors will continue to reap rewards. These “future yielders” present significant opportunities for those that can identify them.


Summary

We believe the Australian equity market continues to provide astute investors with significant opportunities to generate alpha.

The divergent 2016, characterised by a rotation from growth to value highlighted the importance of active management and taking an unconstrained approach to investing. The flexibility to capitalise on opportunities as and where they arise will remain key to delivering returns in 2017.

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