DIVIDING stocks into the traditional camps of cyclicals and defensives will not be much help to investors this year, at least not on its own.
Professional investors say the most important factors in stocks this year are earnings certainty, the effect of currency exchange rates on earnings, and the story underpinning each stock's earnings.
"That's ideally what you're looking for," says Paul Taylor, portfolio manager of the Fidelity Australian Equities Fund. "But first and foremost, you're looking for certainty of earnings and the likelihood of growth. At the moment it comes down to [picking] individual companies."
Taylor says employment website Seek is a good example. "Cyclically, Seek picks up on the theme of the improving domestic jobs market. That's critical for its earnings prospects. But over and above that is the broader theme of the world moving from print to online. Seek is a cheaper and far more efficient place for employers to place job ads. That's an economic and technological driver that is bringing profound change."
Start of sidebar. Skip to end of sidebar. End of sidebar. Return to start of sidebar. Diversified industrial stock Wesfarmers is a similar story, he says. "With Wesfarmers, you're picking up the improving prospects for discretionary retailers, but there are also stock-specific factors that make it attractive. Coles is a fantastic asset and how it is managed will bring big benefits to Wesfarmers. And coking [steelmaking], coal and energy are major positives for it: you're also tapping into those themes."
In general, Fidelity likes companies leveraged to the domestic economy, such as those involved in discretionary retailers, financial services and media, but all of the fund's bigger Australian positions have "a bit of a structural theme and a bit of a cyclical theme".
"We like Commonwealth Bank, Oil Search, Rio Tinto and [education services provider] Navitas, the last of which is more structural than cyclical. Within those general preferences it very much comes down to individual companies and the strength of their earnings prospects," Taylor says.
Andrew Stanley, portfolio manager at Ralton Asset Management, also likes Wesfarmers for the "structural change" coming from the improvement in Coles management, as well as the cyclical upside of rising retail spending. In the same vein, he is looking to participate in the media turnaround through News Corporation, supported by stock-specific factors.
"We think people are missing a lot of the story on News Corporation at the moment, because they're focusing on the US economy. We're comfortable that the US consumer recovery will come, but the point is that News Corp doesn't just rely on advertising for its revenue, it's a subscription story in its pay TV assets. On top of that, it's also had [movies] Avatar and the Alvin sequel and some DVD releases that have done very well recently; it took a lot of costs out of its newspaper assets, which gives it even more leverage to the cyclical recovery; and it is a beneficiary if the US dollar strengthens. So you're not buying it because it's a cyclical stock, you're buying it because there's a number of fundamental factors underpinning the view that it's undervalued at the moment."
Peter Quinton, head of investment research at Bell Potter, says an investor looking out 12 to 18 months should be equally balanced between cyclicals and defensives.
"The cyclicals will give you very strong EPS [earnings per share] growth this year, coming off a depressed base, which is why you can find some that are very attractive on valuation grounds. But some of the defensives have valuations that are attractive compared to the overall market. I don't think you should emphasise one way or the other," Quinton says.
He says his defensive portfolio would be based around bionic ear maker Cochlear, Primary Health Care, Woolworths, retailer Metcash, Goodman Fielder, Tatts Group and energy stocks AGL and Origin.
In the cyclical part of the portfolio, he would have the Ten Network as a prime candidate. "You have to have media to get EPS grunt in your portfolio: the TV networks have the most leverage to an improving economy, because with fixed costs, rising advertising revenue drops straight to the P&L [profit and loss statement]."
To that he would add publishers Fairfax or APN, retailer JB Hi-Fi, David Jones, infrastructure business United Group, freight company Toll, IAG (as a punt: he thinks it has more scope for recovery than fellow insurer QBE) and a couple of bank stocks: he prefers Commonwealth Bank and Westpac, but says any of the big four will serve the same purpose. "Banks are cyclical: they got a [defensive] status in the bull market that they didn't deserve."
Resources are also highly cyclical, says Quinton. If you want you can "drill down" to more targeted single-commodity exposures such as ERA and Oz Minerals, but he believes investors "can't do much wrong" owning the big diversified miners, BHP and Rio Tinto. "The reason is that you pick up exposure to virtually the whole suite of the metals, particularly iron ore and coal."
On a global basis, mining is the ultimate cyclical sector, linked as it is to industrial production and the economic cycle. But the strength of ongoing demand from China has dampened a lot of this cyclicality, says Steve Bartrop, managing director of Lime Street Capital.
"China, like any other economy, has a cycle, but the effect that China is having on the resources industry is obviously massive. When the GFC [global financial crisis] hit we had a sharp downturn in the mining stocks because Chinese demand took a hit, but over the last six months we've seen increasing confidence that Chinese demand is growing strongly and that it's not just export-driven: the domestic economy is growing and driving manufacturing and construction, and that is complementing exports.
"While China is starting to put the brakes on now, historically it has been pretty successful in achieving a soft landing. What that tells you is that the very strong underpinning for BHP and Rio Tinto is firmly in place. The Rio Tinto and BHP commentaries that have come out over the last week or so have been interesting. A quarter ago, it was very much `we're cautiously optimistic': now, it's effectively `we're going gangbusters'. They're quite optimistic in the rhetoric that they're presenting to the market."
As predominantly bulk-commodity producers, Rio and BHP are much less cyclical than companies whose main commodities are metals traded on the London Metals Exchange, Bartrop says. "They're the most cyclical: copper, for example, is the bellwether of the commodities. They've become like gold, which has moved about as a function of the global stimulatory packages, worries about debt blowout and how governments would repay it: it has behaved like a currency.
"Similarly, we see with copper that a rising price seems to drive the commodities plays; the hedge funds get on board and the run starts to carry. BHP and Rio . . . are much more powered by the real underlying demand for coal and iron ore."
Where investors can look to take advantage of the cyclicality of mining is the mid-tier stocks, which have "enormous leverage when commodity prices move," Bartrop says.
"You've seen it with Fortescue Metals: the ability to deliver value to shareholders by developing large, long-life projects that are really quite valuable and have enormous leverage when commodity prices move. An even better example is (coalminer) Felix Resources; the combination of good assets and good management can see a company grow from 50c to a takeover at $19.50. That's where you want to be."
Bartrop says Chinese demand is affecting market levels, and not only in the prices of commodities. "China wants to get long-term access to long-life resources where it can control or have a major influence on the actual project.
"The majors are all trying to buy up the projects that they think might be on China's radar, but if you look at something like Sundance Resources, which is developing the Mbalam iron ore project in Cameroon, that's pretty interesting.
"It's a very large, long-life asset, it has a $US3 billion ($3.4bn) capex [capital spending] bill, but that's exactly the kind of resource that will attract Chinese funding, because they offer such a long life and long-term solution to commodity supply. The Chinese can supply all the rail [and China] gets two million tonnes of iron ore a year from a 50-year mine life."
The beauty of these kinds of situations, he says, is that China's aggressive quest for assured supply has forced other users, such as Japan and South Korea, to become more competitive.
"Unlike the Chinese, they would usually prefer to see a feasibility study completed, but they realise that they have to lock in supply too, so it's becoming more competitive, which can only be good for the companies' shareholders," Bartrop says.
This is not the usual kind of cyclical investing as Australian investors know it, but it taps into the major drivers of economic activity in 2010.
