From time to time, investors should consider whether they have allocated the ‘right’ amount of their equity funds across sectors. Data on market capitalisations are shown in the second last column of the following table for each of the 11 major sectors of the ASX 200. That is, say, the value of stocks in the energy sector is 5.5% of the value of the whole ASX 200. ‘Index huggers’ – who want behaviour in their investments to as closely as possible match that of the index – should try to match these market capitalisation weights.
Depending on which stocks the investor chooses to represent each sector, the investor’s fund will evolve away from these index weights with market movements, and rebalancing from time to time might be desirable. Of course, strict adherence to such rebalancing means that good sectors are being penalised by selling off outperforming sectors to prop up the underperformers. Some latitude in following sector weights is, therefore, highly desirable.
An investor who wants to try to outperform the index needs to take positions on some or all sectors. For most of this financial year it would have been a great benefit to have been ‘overweight’ in the high yielding sectors of financials, property, telcos and utilities. Not only did these sectors provide good yields, they also happened to have strong capital growth, as funds migrated from term deposits to higher-yielding assets.
I contend that there is little (if any) prospect for further capital growth in these sectors as higher prices would drive yields down below that which investors need to compensate them for the additional risk they are taking on over term deposits.
Last week was a stellar week for materials stocks – including BHP, RIO, miners and some building products companies – as this sector’s sub-index grew by 8.4%, and energy stocks grew by 4.8% over the week. Perhaps unsurprisingly, the prices of these stocks started slowly this week. But is it time to get into these and other non-high-yielding sectors?
Rational or irrational exuberance?
As can be noted from our table, all of the forward price-to-earnings ratios (P/E) are lower than the historical. From these numbers alone, it is not clear whether prices are too low or earnings forecasts are too high. At Woodhall Investment Research we analyse lots of company-specific data from brokers to arrive at forecasts for sector capital gains over the following 12 months and a measure of ‘exuberance’ or mispricing.
For example, we are predicting a capital gain of 5.3% for the financials sector (including the big four banks) fundamental (or fair price) but we have priced the sector as over-priced by 8.8%. As a result we need to (approximately) subtract the exuberance from the growth forecast to get an estimate of -3.5%. While the forecast yield is 5.4% (or about 7.5% including franking credits) the combined total return (growth plus yield) is marginal. However, investors who bought at lower prices are facing a very nice yield and do not need to worry about short-run mispricing behaviour.
But, of course, there are many risks involved in these and all sectors. Expected return is only one component of good decision making. Industrials, including mining services companies, were badly hit in 2012/13 to date but are also starting to rebound. Their prospects are also good by our measures.
Consumer staples stocks (such as Woolworths and Wesfarmers) were highly overpriced earlier in the year by our measures, and without the yield to back up such overpricing. When Coca Cola Amatil reported a profit downgrade last week, sector mispricing fell to more reasonable levels. In our thinking, any exuberance measure above 6% is cause for some concern unless another story – such as yield – backs up the mispricing.
Consumer discretionary stocks (such as David Jones and Myers) have the next to lowest projected yield and a worrying degree of overpricing. The weaker dollar might help this sector but its prospects do not look good by our measures. Health and IT are in the middle ground.
But do our measures compare with those of others? Thomson Reuters supplies the broker forecasts of dividends and earnings of companies we use in our analysis. They also provide a ‘consensus recommendation’ for each company, which we aggregate into sector recommendations – which are shown in our table. These recommendations are on a scale of one for a buy to five for a sell. Of course the averaging of recommendations over brokers and companies within sectors, means that the extremes of one and five are almost impossible to attain.
To give this process some clarity I have plotted the sector recommendations against our exuberance-adjusted capital growth forecasts in Chart 1. Each green diamond represents a sector and the yellow diamond is the index. The red line is a line of best fit through the data on the 11 sectors.
Two sectors stand out. The diamond at the top, which is consumer staples, and the sector at co-ordinates 8.5% and 2.5 (well below the red line), which is consumer discretionary. I take this lack of concordance between the two approaches to add an additional layer of risk to both sector forecasts.
So my conclusion is that it might be time to move some funds from high yield stocks to resources stocks – leaving a bit more room for cash-on-the-sidelines to take the place of those funds migrating from high yield.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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