Despite the market being late in the cycle, investment opportunities exist for savvy investors looking to reposition their Aussie equities allocation, as the prospect of volatility returns to the market.

Cast your mind back to February this year, and it’s unlikely you’re remembering the summer heat or the post Ashes celebration. Instead, you’re probably recalling the nervous client phone calls received in the aftermath of 6 February, where $60 billion was wiped off the Aussie market.

Jitters around a strengthening U.S. economy, the prospect of a rise in U.S. interest rates and concerns this would lead to inflationary pressures, saw bourses around the world follow the U.S. into the ‘red’ – reaffirming just how closely entwined global markets are these days.

Move forward two months, and much of the gains lost have since been recovered. But for Lonsec Senior Equities Strategist, Danial Moradi, he is still cautious about the market entering a period of heightened volatility.

“From an earnings perspective, our reporting season was quite positive. However, given the extreme low volatility we have experienced over the past 12 months, it’s likely there may be another spike in the market in 2018, which will be reliant on interest rates and the numbers we get out of the U.S.,” Moradi says.

“So,we are probably entering a period of heightened volatility, despite underlying earnings currently being okay.”

It’s a view supported by Reece Birtles – the Chief Investment Officer at Martin Currie Australia.

“In the 12 months leading up to February, market volatility was low. For example, the VIX (CBOE Volatility Index) spent a lot of time below 10. So, people had become too complacent about extreme low volatility,” he says.

“But that’s changed. As the Federal Reserve raises interest rates to reflect the higher growth environment in America, we can probably expect to see more volatility in the market as a result.”

Cycles don’t last forever

Yet, despite this, Moradi believes the Australian equities bull run, which he says is relatively late in the cycle, isn’t coming to an end – well, not quite yet.

“I wouldn’t say the bull run is coming to an end. We’re in year eight or nine of the bull market on a global equities market basis. So, from an historical perspective, this bull run has gone on longer than others,” Moradi says.

Birtles believes the US is in a much later cycle than Australia, with the US Federal Reserve raising interest rates, the US unemployment rate being extremely low and subsequent inflationary pressures. “So, in terms of late cycle, Australia has still a fair bit more to run compared to America.”

Birtles adds that as you do get nearer to the end of the cycle and growth does slow, you do want assets that are going to be more stable.

“That means real income, so being in property infrastructure utility assets that benefit from rising inflation and are not going to be affected by falling growth, which could occur when interest rates rise,” he says.

“As well as equity income, where you’re earning from high quality companies with strong free cashflows. Their dividends are going to grow faster as a result of that inflation, and provide a growing stable income stream at a time when growth may slow.”

But as for when the Aussie bull run might end, Moradi agrees: that’s the ‘million dollar’ question.

“I don’t think anybody can give you a specific answer to that question without speculating,” he says. “All we can do is look for early signs within the market, such as a pick-up in volatility. But if we do get stability and earnings growth coming through, then there’s no reason why the bull market can’t continue for another year or so.”

It’s a view supported by Birtles: “Timing is a difficult thing. What we can tell you is growth is currently extremely strong and accelerating, both globally and in Australia.

“When you look at the infrastructure spend and the stimulus from the tax cuts in the U.S., and you look at the infrastructure spend in Australia, the strength of the construction cycle here, the extremely strong business conditions for Australian companies and the employment rate, there’s nothing to suggest there is an imminent slowdown at all.

“But cycles don’t last forever,” Birtles warns.

Fair value opportunities

With consensus that the bull market, although late in the cycle, is set to continue, where does Moradi see fair value opportunities for investors, particularly given that Australian equities are at record highs?

“From a sector perspective, the Aussie market is dominated by financials and resources. Currently, the outlook for the major banks is still for high growth, despite the spotlight being turned on them with the Royal Commission, whilst the resources sector has rebounded strongly. For the rest of the market, we’re seeing modest growth, with expectations for industrials being around 4.5 per cent earnings growth,” Moradi says.

“In terms of looking for value, you need to look at company specific opportunities. You need to look for businesses with strong underlying fundamentals, good management, strong balance sheets and other key investment drivers, rather than looking at a sector level.”

He points to companies like Ramsay Health Care as being a market leader with strong fundamentals and earnings growth.

“So, I’m looking for value opportunities from an individual company bottom-up selection process, rather than a broad sector.”

Lonsec’s Head of Listed Products and General Manager Australian Equities, Peter Green agrees, saying it’s a stock pickers market, particularly with the return of volatility to the market.

“These quality listed companies can provide the investor with a hedge to more volatile conditions. The concentration in the the Australian market is still the big four banks, but you need to consider that with expected lower economic conditions, this will mean a lower growth environment for the banks.”

When looking for quality income generating companies that are going to provide a strong and growing dividend, Birtles believes the most important characteristic investors should be looking for is overall “quality” of the company.

“We determine the quality of the company by assessing the moat of the business, that is: the strength of the business, the barriers to entry, pricing power, the competitive advantages in terms of cost position, the level of debt, governance, and whether the company is really turning its profits or earnings into cashflow.

“That’s why quality assessment is important to finding good income generating stocks, than any broad sector classification.”

He adds that if you look at the equity income strategy, the expected dividend yield (including the benefit of franking credits) is currently in excess of 7 per cent, which has been a relatively stable percentage for a number of years now.

“So, there is nothing to suggest there’s a lack of value in the Australian market. You have to remember that dividends are growing as a result of better profit growth from Australian companies.”

Three quality stocks Birtles likes include IOOF Wealth Management, AGL Energy and JB Hi-Fi.

“IOOF Wealth Management has an 8 per cent expected dividend yield in the next 12 months, and will benefit from the synergies and the accretion of the ANZ deal. And it has a very strong cashflow stream, given its capital light model.

“Similarly, AGL Energy’s dividend yield is expected to be 7.4 per cent over the next 12 months. Clearly, it’s still benefiting from higher electricity prices, especially on commercial and industrial companies, as their contracts roll over.

“And then there is JB Hi-Fi, which we view as one of the world’s best retailers in terms of sales productivity and low cost of doing business. And with the Good Guys acquisition, it continues to grow strongly. It has an expected dividend yield of 7.7 per cent over the next 12 months.”

Be mindful of trends

And what of any trends that are likely to impact the Aussie equities market over the coming years?

According to Green, the obvious trend over the past 12 months has been in resources, where there has been strong earnings appreciation across the resources sector. “And that’s just as the market turns towards a reflationary type environment, where commodities have tended to do better.

“Going forward, there are some concerns around the inflationary environment, but I still expect commodities to do okay. Ultimately, in this type of environment, it’s about taking a bottom-up view of quality stocks, which will continue to do well.”

And what about the chase for yield?

“AREITs and bond proxies have underperformed of late, but again you have to look at the underlying fundamentals, like how much debt businesses are carrying and what exposure they have to potentially high interest rates, and what level of interest rates you’re pricing in,” Moradi says.

“The Australian yield curve does tend to move in tandem with the U.S., but it’s driven off different fundamentals. As yields move higher, you’d expect that would be a headwind for the share prices of particular sectors. So, if interest rates are above what the current market is expecting, then that sector is likely to underperform.”

In terms of geopolitics, Green concedes there is concern around the imposition of U.S. tariffs on trade, which he says, could cause “market volatility as a result of a global trade war”.

“So, even though we’re quite late in this bull market, we can still expect to have events, like the one we recently saw in February, which come as a result of increased volatility, which we’re now seeing,” he says.

According to Birtles, the strongest trend he is currently seeing in the market, is the number of companies that ‘beat’ their sales revenue forecast, compared to ‘miss’ their forecast, which is a positive sign for the Australian market. Indeed, he says the ‘beat’ ratio was 39 per cent, compared to ‘misses’ of 12 per cent.

“That ratio of ‘beats to misses’ is far superior to what we’ve seen for many years in Australia,” Birtles says. “As a result, we’ve seen upgrades to revenue forecasts and we’re seeing Australian industrial companies with revenue growth accelerating on average from 2 per cent over the last five years, to currently over 5 per cent.

“So, that revenue acceleration is very important in terms of sustainable growth of earnings and is a very good sign for the Australian market.”

It’s always about diversification

Given the market is late in the cycle and with Australian equities approaching record highs, Lonsec Head of Investment Consulting, Veronica Klaus believes it’s important for any planner considering repositioning their clients’ portfolio to a more defensive allocation, to keep in mind that the portfolio needs to be built on the client’s end objectives.

“We need to consider whether the portfolio is for retirement or for accumulation. That’s because as we increasingly enter into periods where markets are becoming more volatile, we need to be very focused on the risks, which are magnified when in retirement, and the impact that this volatility has on client portfolios,” Klaus says.

She also believes planners need to look at how the portfolio is constructed and what the different positions within the portfolio are trying to achieve.

“That means understanding where we’re getting our beta and alpha exposure from. And then look to other strategies we need – whether it be risk control, which is increasingly important, and income for retirement portfolios.

“When we’re late in the bull market cycle, you really have to start focusing on what the greatest risks are to your portfolio and to your Aussie equities. So, that means, how can you bring in elements of risk control to at least dampen some of that volatility and limit drawdown?”

Klaus recommends looking at strategies where the manager has a greater focus on absolute return, rather than just matching the index.

“Whether that’s by taking calls on equities versus cash, whether that’s using short positions and so forth – it’s a very different approach to managing a traditional equities portfolio. So, you should look to increase that in your portfolio. And then you look to focus on where there is potential alpha still left in the market, and try and get some of that into your portfolio.”

But over and beyond everything else, Klaus emphasises that given the current market environment, portfolio diversification remains the key consideration for any investor.

“Heading into a potentially more volatile market environment, it’s incredibly important to have true diversification in your portfolio,” she says. “So, it’s vital that planners use an array of different strategies that encapsulates the likes of risk control and bottom-up stock selection to minimise risk.”