The challenge with Aussie shares – Morningstar

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This is our last investment outlook report focusing on 2015 – we promise. It’s from Morningstar, which should be – at least in theory – dispassionate about its views. In a nutshell: Australian shares present a challenge for investors next year.

Morningstar’s annual outlook for the Australian share market says that the decline in prices during the second half of this year has at least improved the average price-to-fair-value assessment, making the market its cheapest since 2012. “This indicates to us that, in the long-run, shares should generate a total risk-adjusted return equal to their collective cost of equity of about 10 per cent a year,” they say.

Other highlights from the report include:

>  The Australian economy will be buffeted by external headwinds, mainly related to commodity prices and reduced volume growth associated with a slowing Chinese economy. Internally, fiscal issues will remain a source of concern. It is becoming increasingly likely easier monetary policy and a lower currency will be required to stimulate economic activity while the terms of trade and government revenue continue to weaken.

>  In this subdued economic environment, sectors providing staples or necessities should outperform those more sensitive to expansive forces. The thirst for sustainable yield should continue to support companies with defensive qualities, such as those with wide or narrow economic moats and medium or low fair value uncertainty like the major banks, Telstra, Woolworths, Wesfarmers, unregulated utilities, and infrastructure.

> There’s no change to our bullish long-term view on energy prices, oil in particular, as new sources become harder and more expensive to produce. Australian mining and energy companies, particularly the large ones with economic moats, are positioned to continue to extract cost savings from contractors, suppliers and labour.

> The recent commodity price selloff will increase budget pressure on resource companies, which are likely to continue to reduce capital expenditure. Consolidation of supply among the majors and the reduction in expansionary capital expenditure will provide significant headwinds for companies servicing the resources sector.

> The iron ore price has corrected rapidly in line with softer demand and increased volumes. We expect it to remain near current US$70-a-tonne levels for the foreseeable future with US$75 a tonne, longer term, from 2020. Fundamentals may worsen before improving, though significant pain has already been absorbed.

> BHP Billiton and Rio Tinto are strong enough to ride out the storm and consolidate market shares. We remain very wary about the outlook for and sustainability of high-cost producers such as Arrium, Atlas Iron, Fortescue Metals, and Mineral Resources. BHP remains a best idea with appeal from the strong balance sheet, diversified earnings base, cost cuts, and the relatively attractive dividend yield.

> Trading conditions for the major banks remain favourable, with improved consumer and business confidence expected in 2015. Lending and deposit growth momentum is surprisingly firm despite headwinds. Additional capital requirements may feature, but we don’t expect material disruption to earnings growth in the longer term. Our preferred exposures are the business-focused Australia & New Zealand Banking Group and National Australia Bank, based on attractive discounts to fair values.

> The medium-term outlook for general insurers is reasonably positive, but the current benign claims environment is unlikely to continue indefinitely. Offsetting potentially slower top-line growth and increased claims costs is the focus on tighter underwriting standards and improved productivity. Narrow moat-rated QBE Insurance and no-moat Insurance Australia Group are undervalued.

> Listed property stocks with reliable income streams and a solid growth outlook are increasingly expensive. Narrow moat-rated Westfield Group is high quality but trades at a 10.0 percent premium to valuation. Our top pick is Goodman Group trading at an 11.0 percent discount to valuation.

> We expect subdued earnings growth from most industrial stocks in FY15. Many are nonetheless well-positioned for a recovery in economic activity, apart from the resource-facing engineering, construction, and mining service sector. Most industrials are tentative about the timing of a recovery and remain reluctant to commit to significant capital expenditure on growth initiatives.

> Residential building activity remains strong, but with housing starts at a decade high, further robust growth is difficult to envisage in the medium term. We anticipate building materials firms will achieve strong earnings growth in 2015. But we continue to wait for the wave of infrastructure construction projects, driven by government spending and private/public partnerships, to emerge and assist the construction materials sector.

> Engineering and construction companies with significant exposure to the mining and energy sectors face a considerable decline in domestic capital expenditure and project work over the next three to four years, as the resource investment cycle slows. This testing outlook will prevent any swift or sustained bounce in earnings and cashflow.

> We expect retail sales to improve in 2015, supported by improving consumer confidence, low interest rates, and elevated asset prices. The lower $A may however crimp earnings in the face of stronger sales growth. In this environment we favour stocks less exposed to potential currency-related volatility. Woolworths is our preferred exposure, and we see little value elsewhere in retail at present.

> The challenging consumer environment is having a significant impact on media companies. There’s increasing divergence between the structurally-challenged low-quality traditional media companies and the online classified aggregators. Our preference is for the latter, all of which have economic moats, but at present none are trading at a sufficient margin of safety to our fair value estimates.

> The healthcare sector trades above our fair value estimate and has done so for some time. Investors continue to pay a premium for healthcare stocks, attracted to their defensive earnings streams. This is understandable given the high presence of economic moats and structural revenue growth driven by ageing Western populations. However, we believe the market is placing a higher valuation on most than is warranted. IVF service provider Virtus Health’s shares remain at a discount to fair value and continue to be a best idea.

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