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How high can the rocket fly?

25 March 2019

Dougal Maple-Brown

Dougal joined Maple-Brown Abbott in 2001 and was appointed Head of Australian Equities in 2009. His responsibilities include equity analysis and portfolio management. Dougal attended the Advanced Management Program at Harvard Business School in 2014.

As at early March, it is hard to make a case that the “macro” has altered much: neither Brexit nor the US/China trade wars are any closer to a conclusion.  Probably the only tangible change is the potential path of US interest rates with the Federal Reserve signalling in late 2018 that further rate rises are now less likely.

Domestically it is a similar story.  House prices have continued to fall but the ultimate impact of this on the broader economy is still an “unknown”.  We have a federal election later this year, where the major opposition party is proposing some quite far reaching policy changes (for example abolishing cash refunds for surplus franking credits).  However the election is still in the future and predicting both its outcome and what policies are ultimately enacted by a new government is no easier today than it was yesterday.

In terms of what has changed, similar to the overseas experience, the Reserve Bank has now signalled that the future path of domestic interest rates is more broadly balanced (from a prior tightening bias).  Somewhat ironically, this more balanced prognosis was given in the context of an unemployment rate that continues to fall!  It is fair to say that the final Royal Commission report into banking and financial services that was delivered in February was not as bad as some had feared: causing the major banks to rally.  But frankly, all that the last six months or so has shown is that the “animal spirits” are alive and well: firstly on the downside and then more recently on the upside.

With the Australian market around 6,200 we would view it as fully priced.  We have had a long held overweight to the Resource sector but with strong share price gains over the last three years we have reduced our overweight position.  For example, Rio Tinto has just reported an annual profit broadly flat on the prior year, yet the share price is almost one third higher!  We are underweight the banking sector: valuations look attractive but the sector faces a laundry list of challenges.

The most interesting section of the market remains the Industrials: interesting in the sense that quite extreme valuation dispersion is evident.  As can been seen in the chart, the value or low price/earnings (P/E) end of the Industrials market is trading broadly in line with history.  However, the growth or high P/E end of the market is trading at a significant premium to historical averages.

Whilst various theories have been put forward to justify this premium, lower interest rates/lack of true growth stocks, we are clearly in the camp that “this time isn’t different”.  In our experience very few stocks can sustain the growth rates required to justify such eye watering valuations.  Thus whilst we remain cautious of the market overall, we remain particularly wary of many of the high priced Industrial stocks.

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Disclaimer: This information was prepared by Maple-Brown Abbott Limited (Maple-Brown Abbott) ABN 73 001 208 564, Australian Financial Service Licence No. (AFSL) 237296, and is intended to provide general information only, and does not have regard to an investor’s investment objectives, financial situation or needs. The content does not constitute advice and should not be relied upon as such. Our presentation, including comments we make about individual stocks, is intended only to explain our approach to managing funds. In discussing individual stocks or other investments we do not make any recommendation or give any statement of opinion that is intended to influence anyone in making an investment decision. Investment advice should be sought in respect of individual circumstances. Past performance is not a reliable indicator of future performance. Maple-Brown Abbott Limited does not make any representation or give any guarantee as to the future performance or success of, the rate of income or capital return from, the recovery of money invested in, or the income tax or other taxation consequences of, any investment.