Things Are Looking Up Down Under, Part II

He says Ausdrill has solid long-term contracts, a good customer suite and is also growing in areas such as West Africa, where there is significant mining-related activity. Although WorleyParsons looks expensive currently, Hook says he believes the company will benefit from a marginally weaker Australian dollar and all the mining and oil-related projects taking place.

"You've only got to look at some of the contracts they have picked up recently for an idea of how much activity is happening in this sector," he says. "We are not buying this for 2011 but more for 2012 and beyond."

Fidelity's Taylor says he has an overweight on the industrials sector due to key positions in mining services groups, engineering firms and specific structural growth companies such as private airport owner Map (MAP) and employment website operator Seek (SEK). "[This year] should be not only a strong demand year for these companies and sub-sectors, but they should also be able to achieve quite strong pricing power through the year," he says.

"Mining services and engineering firms should benefit from the very significant investment planned in major resource and infrastructure projects. This strong demand should lead to an improvement in contract terms like a move to a cost-plus basis and higher charge-out rates."

Meanwhile, Greencape Capital's Pace says he's finding specific opportunities, including global packaging company Amcor (AMC) and toll roads operator Transurban (TCL). "We like Amcor because it made a great acquisition at the height of the global financial crisis," he says. "It bought Alcan Packaging, which was the next biggest player in the European flexibles market. They bought that off a distressed Rio Tinto at the time and paid 5-5.5 times EBITDA (earnings before interest, taxes, depreciation and amortisation) and there is significant synergy to be had over a two-to-three-year period. So what they have basically done is transformed the European flexibles market by taking out the next biggest player."

Pace says Amcor is now four times bigger than its next largest rival and is competing with a number of cash-conscious private equity-owned or private companies. "Amcor is better managed than it has ever been and it operates in an industry that structurally has never been in better shape and we continue to expect an ongoing re-rating of Amcor as an investment proposition," he says.

Pace says Transurban pays a yield of around 4.5%-5% and has strong potential earnings growth. "What I really like about this one is that it has potential earnings growth of 10%-15% out to 2015," he says. "Its growth is underwritten by moderately improving traffic volumes--so we are talking about 1.5%-2% growth in traffic and mandated consumer price index plus toll increases and keeping costs flat over the next three years."

New Reality for Banks Prompts Caution
After an impressive recovery from March 2009 to April 2010, the share prices of the major Australian lenders have fallen and stagnated amid concerns over high wholesale funding costs, slowing credit growth and importantly the new Basel III global bank rules. The rules, still under development, will essentially require financial institutions to hold more cash on hand, particularly during good times.

The factors combined have made managers cautious on the outlook for the earnings and dividend growth potential of the major banks. "You have seen a step down in credit growth in Australia from the mid-to-high teens to the mid-to-high single-digit levels," AMP Capital Investors head of Australian equities Greg Barnes says.

"There is a number of international structural changes going on driven by Basel III and a number of significant changes that have flowed on from the GFC that will have an effect on the banks.

"The banks are great companies, tremendously well managed and a strong industry in Australia and they have proven their capacity by their performance through the GFC, but there is a period of adaptation that they need to go through as a result of those changes."

Barnes adds that the banks will need to adjust their growth profiles, cost base and manage their margins as they go through the process. "So it's another area that we think will probably be softer compared to the overall market," he says.

Pace says banks look reasonable value relative to where they have traded in a price/earnings sense over the past decade. "But the other thing to keep in mind there, and where it makes it a difficult judgment call, is that credit growth over the last decade has been a multiple of gross domestic product," he says. "We would contend that credit growth over the next 10 years will be a lot harder to come by than what it has last decade. That would imply that banks should be trading at a discount to where they have historically."

He says the Basel III global bank rules will require more capital to come from deposits relative to wholesale funding sources and put upward pressure on the loan-to-deposit ratio for all the major banks. "ANZ (ANZ) will be better placed to cope with these new regulations as it has access to Asian deposits, and CBA (CBA) will also be better placed due to its retail deposit dominance," he says. "Westpac (WBC) and National Australia Bank (NAB) will be less well placed."

Hook says it's too early to say how Basel III will affect banks, but in the shorter term it won't be perceived as a positive because it requires banks to strengthen their balance sheets. "But clearly having a strong banking sector is important in this country, so longer term it should be a positive thing," he says.

Retailers Battle the Power of Online
The retail sector is undoubtedly facing three major headwinds--including already weak sales, the prospect of higher interest rates this year and the one that has caused all the rage in the media: consumers' move to online shopping.

Online retail consumer spending in Australia in 2010 is expected to account for around 5% of total retail sales, with nearly half of that going to offshore shops, according to research by consulting company Frost & Sullivan. It is expected to steadily increase until it catches up to the US and UK's 10% figure.

The trend has retailers, including Harvey Norman (HVN), Myer (MYR), David Jones (DJS) and Target, so worried that last month they decided to launch a campaign to have the goods and services tax (GST) imposed on purchases under $1,000 from overseas sites.

"We know that people are increasingly purchasing online offshore and why wouldn't you?" Barnes says. "As a consumer you are looking for the best value and if the best value is online offshore, then people will do that.

"I think it's very hard for retailers to change people's behaviour. What they need to do is find a way of embracing that and making money out of it."

The factors have led SG Hiscock & Co to have a downbeat outlook on the retailers. "The domestic economy is pretty slow at this stage and people are looking for bargains, so it's kind of an area we're staying well clear of," Hook says.

It's not a question of getting things online for 10% cheaper; it's very often 40%-50%, he says. "So even if they add the GST and import duties on goods bought overseas by Australian consumers, it wouldn't do much and certainly wouldn't stop people from buying online because of the range, choice and they arrive very quickly," he says. Australian retailers will have to rework their approach and may even take a clip on the margins, he adds.

To add to the consumer discretionary sector's pain, the Australian Retailers Association expects retailers, including those businesses that may have been affected by the floods, will be hit hard by the federal government's flood tax as consumers tighten their purse strings. "While the cost of the flood tax will differ from family to family, the idea of a new tax is enough to significantly dampen consumer confidence to spend at a time when retail sales are at depleted levels," the Association's executive director Russell Zimmerman says.

Big Names Preferred in Defensive Sector
Like industrials, portfolio managers believe there are good opportunities in specific defensive names as they are generally unaffected by rising interest rates. "In the healthcare sector, I like the industry leaders and/or those benefitting from structural growth themes," Fidelity's Taylor says. "Healthcare should continue to see strong structural growth and should be relatively unaffected by the rising interest rate environment."

Pace says he likes medical device manufacturer ResMed and biopharmaceutical company CSL (CSL). "We think that CSL's sales and margins will benefit after one of its major competitors had to pull their products from various major markets around the world due to product quality concerns," he says. However, he is less optimistic on Telstra (TLS). "The stock provides plenty of yield but how sustainable is it? Our strong view is that it isn't sustainable," he says. "A lot of the structural issues that Telstra has had to deal with over the years have not gone."

Hook says he expects Woolworths (WOW) and Wesfarmers-owned (WES) Coles to perform reasonably well and also favours CSL and Ramsay Health Care (RHC).

"We still like Ramsay Health Care because they have good management, good brownfield operations coming into fruition and they have diversified overseas, so any local legislation impact will affect the company less so than pure domestic operators," he says.

This article first appeared on Morningstar.com.au, a sister site of Morningstar.co.uk.