NZ Equities Strategy - Playing a Tight Game

1 Dec 2011

The global investment environment remains volatile, with rising concerns over European sovereign debt issues and a very slow recovery in the USA, as well as a potential slowdown in China’s strong growth rate. The US, Japanese and UK markets have fallen around 12%-14% in the September quarter, and several of the major European markets have fallen by about -25%. Australia is down around -13%, but New Zealand has held up much better, with the NZX50 down -5% and the NZX50 Gross down only -3%. This is a pattern of local outperformance which we expect to continue.

Growth is beginning to improve in New Zealand and is likely to positively surprise next year, driven by exporters, particularly in agriculture, but also a modest improvement in consumer demand. Australia and New Zealand are much better placed than most developed economies, with relatively low public sector debt and a significant production base of commodities which are in demand from the rapidly growing Asian developing economies.

The New Zealand equity market is about 5%-10% cheap on the key valuation metrics of PE ratio and price to valuation, and we estimate New Zealand market earnings are still about 14% below trend. Although further FY12 downgrades are possible, we expect revisions for subsequent years to turn positive. We are maintaining our central scenario gross return at 15%-20%, assuming little change in the market PE ratio, but 5%-15% annual average earnings growth across FY12 and FY13.

In an attempt to identify the best value stocks in this volatile market, we have revisited our earlier "Hunting for Alpha" screen which was based on our DCF valuations. We have re-run that methodology, but added two PE–based factors. Six stocks make the cut on all three measures: FBU, HLG, MHI, SKC, STU and TWR.