investment themes for 2011

Summary of my thinking:
1. Interest rates will start to fall
2. The A$ will fall
3. Discretionary retail stocks (MYR, SFH, NBL, PBG) will outperform
4. US$-denominated earners (WDC, QBE, ANN, CPU, RMD, COH) will outperform.

I recognise that this investment stance is probably at stark odds with current conventional wisdom (which is added reason why I am comfortable with it; invariably, little money is made thinking like the herd).

The retail sector is not just unloved, but almost hated, at the moment, and the Recency Phenomenon has the herd collectively saying "A$ at parity is bad for QBE, WDC, ANN, CPU, etc."

Let me substantiate my prognosis:

Firstly, I have utmost respect for RBA Govenor Glenn Stephens (I think his standpoint on the creation of a Prospertiy Fund is a prescient one), but I think he has overcooked monetary tightening.

Long story short: recent economic data (which would have been gestating even before the last rate increase) are decidely weaker than economist expectations.

And the weakness has not been confined to isolated pockets of the economiy either; it is considerably spread (with the exception of the resources sector): construction, tourism, retailing, maufacturing, financial services are all demostrating weaker-than-expected performance.

Listening to the Metcash results presentation this morning has amplified exactly what numerous economic participants have been saying: DEFLATION.

Now I am no deflationist conspiraty theorist or scaremonger, but what is increasingly observable in larger pockets of the economy is the difficulty of enterprises to pass on price increases to their customers. A lot of this has to do with the strength in latter parts of 2010 of the A$, and the relatively quick dampening effect this has on inflation.

Just as we were starting to import deflation due to the A$, the RBA has been ratcheting up rates, adding to the A$'s appeal as a high yield currency (particularly compared with the rest of the developed world where real interest rates have been negative in 2010), thereby further lowering import prices.

For this reason, my big call for 2011 - and I don't see it factored into the consensus view of economists - is that interest rates will be on hold for next year, and I put a 50% chance that they are actually lowered by the end of the year.

DISCRETIONARY RETAILERS
From a money-making point of view, then, it follows that if interest rates are indeed at their peak, then the retail sector should become of interest to investors willing to be a bit contrarian.

What I particularly like about this theory is that, just as we are currently experiencing the perfect storm for discretionary retailers in the shape of a period of heavy discounting cycling a previous corresponding period of government-sponsored consumer stimulation, this time next year, retailers will be cycling today's weak headline sales performance which is characterised by acute discounting and deflationary pressures.

Combine that dynamic with a developing view that interest rates could fall, and you have the conditions precedent for outperformance of dicretionary retailers.

And, most important of all, its not as if their share prices are discounting this outcome; in fact, it looks to me like some of these stocks are priced for ongoing tough trading conditions to perpetuity, to wit:

MYR:
FCF/EV = 8.9%
EV/EBITDA = 6.2x
DY = 6.7%
P/E = 10.4x

SFH:
FCF/EV = 10.3%
EV/EBITDA = 4.3x
DY = 7.1%
P/E = 9.4x

PBG:
FCF/EV = 11.8%
EV/EBITDA = 5.4x
DY = 6.9%
P/E = 8.6x

NBL:
FCF/EV = 14.4%
EV/EBITDA = 3.4x
DY = 7.9%
P/E = 9.0x


US$-DENOMINATED EARNERS
If my thesis on interest rates is correct, then this will have implications for the sustainability in the strength of the A$ which, I believe is still pricing in an ongoing tight monetary regime.

Some of the high-quality, investment-grade stocks currently under an earnings headwind from due to the A$'s strength are QBE, WDC, ANN, CPU, and RMD. Under a falling - or even a flat - domestic interest rate landscape I believe the A$ would ease, effectively creating an earnings tailwind for these stocks.

And every month US Treasury yields continue rising as they have over the past four months (in the face, I might add, of renewed European sovereign debt concerns as well as military ructions on the Korean peninsular, which highlights just how overvalued US Treasuries seem to be), adds impetus for a weaker A$, in my considered view.


In closing, while I tend to be a contrarian investor, I do not do so simply for the sake of it. But when, during a once-a-cycle storm, the market prices stocks as if the cycle was dead forever, which I believe it is doing in the case of discretionary retailers and offshore earners, then that, I believe is when the downside is limited and when contrarian thinking creates wealth.

Prudent investing

Cameron