This document is intended for the general information of financial advisers only. Fidelity does not authorise distribution to retail investors.

January 2008

Paul talks about the year that has passed, the outlook for 2008 and his investment style.

Q: What were the highlights of 2007?

A: The most interesting aspect of 2007 was the tug of war between sub-prime and China.

When sub-prime struck earlier in the year, a tussle began between emerging markets and the US economy over which has more influence on the global economy these days.

Other important aspects of the sub-prime crisis were that it triggered a repricing of risk and heralded the return of volatility. It was a remarkable crisis in that sub-prime paper was held by investors all over the world, from German banks to Australian city councils. This was bad in the sense there was uncertainty about where the paper was being held. On the other hand, it meant that the losses from sub-prime were spread around the world. The global financial system is healthier because this risk had been well diversified.

One other event of note in 2007 was the decline of the US dollar and what this meant for Australian company earnings. About 30% to 40% of the earnings of Australia’s largest companies are derived from overseas, so changes in the value of the currency may have an impact on company earnings.

Q: What were the lessons for investors from 2007?

A: The sub-prime crisis showed how connected the world is today. Poor lending practices in the US had a phenomenal impact around the world and were felt in Australia, for example, in the issues surrounding Rams Home Loan Group and Centro Properties Group.

The lesson for investors is that you need to be doing your homework and focussing on fundamentals because when risk is repriced upwards the impact on stocks can be significant and quick.

These fundamentals at the company level, where I approach investing, are the quality of balance sheets, the strength of management, a company’s position within an industry and the outlook for that industry.

If you invest in poor quality stocks, especially ones with low liquidity, you can get caught out in these situations.

Q: 2007 saw a very narrow rally in stocks. Do you think this is healthy?

A: It’s neither healthy nor unhealthy. It shows how important stock-specific factors are for investors. You can’t just assume that because resources and energy sectors look good you can buy any stock.

In the resource sector, for example, some companies manage their costs better than others. Big diversified resource companies generally have more power to manage their costs than a small, new miner might.

The narrow rally just reminds us that we need to look at the dynamics of the company before investing. Can it control costs? Does it have pricing power? Is the management capable? What does the balance sheet look like? These are examples of questions that need to be asked.

Q: How do you see the resources boom playing out given the increased risks of a us recession?

A: The US economy is not as dominant as it once was in terms of its effect on the earnings outlook of Australian companies. This was demonstrated in 2007.

Through 2007, news from the US showed that the US housing market was in trouble. Commodities sold off on expectations that demand would fall, especially copper because the metal is used extensively in houses in the US.

But in no time, commodity prices recovered because actual demand stayed strong. Demand has remained buoyant because China’s economy is still growing at 10% a year and because the rest of the world is performing. The Middle East is booming, and so are Turkey and Russia.

In a sense, there was a tug of war between the US and emerging markets in terms of their importance for the world economy and, for now, emerging markets have largely won.

For those who believe in the “stronger-for-longer” resources cycle and I’m one, it is a 20-year story. The industrialisation of India and China means that commodity prices are likely to remain high over the next two decades. But prices won’t move in a straight line. There will be some mild upticks and downturns within this trend. 

Q: What's your outlook on earnings?

A: The outlook is for solid earnings growth with good dividend yields. I expect the macro-economic environment to remain strong, even if interest rates continue to rise. Unemployment is low. We have tax cuts coming through. Spending on infrastructure is rising. High commodity prices are likely to support mining stocks.

In coming years, we probably won’t see the big discrepancies at sector level that we have seen in recent years when resources and energy were up 60% to 70% or even more. We are likely to see a compression across sectors. Whether it’s property or banking, you’ll see a tighter range at the sectoral level. But you will see more dispersion in individual companies. I think there will be a greater opportunity at a stock level to pick the quality companies.

Stock-specific factors are likely to be of more importance this year because much will depend on the ability of companies to manage the cost pressures that are building. Companies that have pricing power will be able to maintain their margins as will those that can make cost savings elsewhere.

Valuations look reasonable, the dividend yield is still good and earnings growth is still around the high-single, low double-digit percentage rates. These factors point to favourable long-term returns.

Q: What's the outlook for local equities in 2008? Will we achieve double-digit returns in 2008? What are the risks for local stocks?

A: Investors need to set their expectations closer to the Australian share market’s long-term average nominal return of around 12% rather than the 20% plus returns we have seen in recent years.

Studies show that the Australian share market has been one of the world’s best performers over the past 100 years or so for some strong fundamental reasons.

A key one has been strong population growth because that leads to faster economic growth. The latest figures show Australia is enjoying population growth of 1.5% due to more births and immigration. This is high by world standards.

Other fundamentals include an excellent natural resource base, strong corporate governance, high quality companies and a culture of high dividend payouts forcing companies to be efficient with capital.

These long-term fundamental drivers look set to remain in place for at least the next decade. So over the next 10 years or so investors can expect a nominal return that bounces around the longer-term average of about 12%.

The biggest risk would be if a slowdown in China occurred at the same time the US economy was struggling.

Q: What stocks/sectors do you like?

A: I must emphasise that I am a fundamental bottom-up stock picker so I don’t analyse the market on a sector basis. But when you aggregate my views on companies, I see that the retail sector looks reasonable.

The larger resource stocks are well placed though speculation is propping up some of the smaller stocks in the sector. Non-residential construction and firms servicing resources companies enjoy bright outlooks, as do diversified financials and healthcare stocks.

But I want to stress that I focus on the company level not the sector level when building a portfolio. In today’s environment of higher interest rates and, possibly, slowing global growth, I am looking for structural rather than cyclical growth from stocks.

I’d prefer to buy quality over poor management, growth over non-growth and good balance sheets over mediocre ones. I’m looking for solid, quality, strong cash-flow businesses. Companies that fit this bill at the moment are Woolworths Ltd., Commonwealth Bank of Australia Ltd., AMP Ltd. and Rio Tinto Ltd. 

Q: What research resources can you call on within fidelity to help you select stocks?

A: I am backed by a team of analysts who in turn can call on the insights generated by Fidelity’s more than 900 investment professionals around the world.¹ Specifically for Australian stocks, we have five analysts based in Sydney and six analysts based in Hong Kong who cover Australian companies as part of their regional sector research.²

Because about 30% to 40% of the earnings derived by Australia’s largest listed companies are generated from abroad, input from our research offices around the world is crucial to our stock-picking process.³

Fidelity’s global coverage ensures that we understand the business, economic, political and social landscapes in each region companies operate. This local knowledge is communicated worldwide among portfolio managers and analysts.

Reference to individual companies is for illustration purposes only and does not constitute a recommendation.

Paul Taylor is the Portfolio Manager of the Fidelity Australian Equities Fund and Head of Australian Equities for Fidelity International Ltd. (“Fidelity”). Paul, who is based in Sydney, joined Fidelity in 1997 as an Investment Analyst in London. He initially covered the European diversified industrials/engineering sector before becoming the lead European bank analyst.

Paul then assumed the role of European and Global Financial Sector Research Leader where he was responsible for co-ordinating all European financial sector research. Paul was promoted to the role of Portfolio Manager for the Fidelity Funds Global Financial Services Fund in 2002.

He returned to Sydney in 2003 to establish Fidelity’s Australian equity team.
Paul holds a Master of Finance from the London Business School and a Bachelor of Commerce and Business from the University of Queensland.

 

 

 

• China’s soaring share markets
• The outlook for 2008
• Why the US dollar is falling
• How “anchoring” can confound investors

• Oct 07
• July 07