The manager of an Australian equities fund for Fidelity, Paul Taylor, gives his views on the outlook for the Australian economy and his investment stance. He says the underlying reasons for Australia's strong economic growth should remain in place.

Paul Taylor has managed the Fidelity Australian Equities Fund since it was first set up in June 2003, for local investors who wanted to tap Fidelity’s well-known bottom-up stock selection approach. 

The fund has been one of the best performing Australian equities funds in the country. Since its inception, the fund has provided an annualised return after fees of 16.83 per cent a year, out-performing the market by more than 4.5 per cent a year. This performance places the fund in the two of major Australian equity funds over the five years to 30 November 2009, according to Bloomberg Fund Search.

It is also one of the most popular Australian equity funds, with Fidelity receiving greater net inflows than any other such fund in the past two years, according to Plan for Life at the end of June 2009.

Where do you see the Australian economy and sharemarket heading in the next 12 months?

The Australian economy has been very resilient through the global financial crisis. Australia benefited from its economic links with China, the strong balance sheet of the Australian Government, the reduction in interest rates by the Reserve Bank of Australia and the fact that Australian financial companies had limited exposure to the sub-prime crisis.

Recent Australian economic and corporate earnings data have shown signs of improvement. Investment growth is positive, industry capacity ultilisation levels have started to rise, private consumption has accelerated and unemployment remains below 6 per cent. As corporate Australia stops de-stocking and starts to restock in late 2009 and the first half of 2010 as well as starts to move from a cost-cutting focus to one of growth the underlying demand in the economy should grow relatively quickly. 

I believe that we will see earnings upgrades for the market over the next 12 months, as this expected strong economic growth aids companies sales growth levels and margins.  As a general rule, the market normally under-estimates the decline in margins on the way down and also under-estimates the improvement in margins on the way up - and I do not see this cycle as any different. Combining this good environment with an overall Australian market that looks attractively valued on a long-term, or through the cycle basis, means that I still see a relatively positive Australian stockmarket performance for the next 12 months.

It is also important to remember that we have just seen the second worst stockmarket decline in Australian history and, while we have seen some recovery from the March lows, if previous cycles are any guide there is still reasonable upside in the Australian market.

As for individual companies, if we look back to 2008 it was those companies with very strong balance sheets that did exceptionally well. Since the market bottomed in March this year, it has been the cyclical stocks that have taken over that market leadership. I believe these cyclical companies with attractive valuations and good earnings upgrades will continue to do well in the short-term.

As we head into 2010, there could be a transition towards growth stocks that have stable and predictable earnings and the market feels comfortable with the certainty of their growth rates.  As we move into a potentially lower growth environment, companies with high certainty in their growth will be bid up by the market. I would expect to see that transition from cyclical companies towards growth companies as we progress through 2010.

Looking further ahead, Australia has been the best performing market in the world long-term and I believe the structural reasons for this strong long-term performance are still very much in place for at least the next decade. Australia has historically benefited from its strong population growth, its excellent and low cost natural resource base, its strong corporate governance environment, its good diversity of quality companies and its high dividend yield and high real dividend growth. These key structural drivers are still very much in place. The current cyclical recovery and the resilience of the Australian economy will benefit investors, but these long-term structural drivers are the key reason I believe investors should be looking at Australian assets.

What sectors and stocks do you like most at the moment?

I favour companies leveraged to the domestic economy, like those involved in the consumer, financial services and media sectors. The fund is over-weight discretionary retailers as well as food and staples retailers that have strong franchises, good management teams and good industry structure. It is also over-weight diversified financial companies due to their attractive valuation and favourable growth prospects.

Has the fund taken advantage of the recent flurry of capital raisings?

A range of capital raisings were made at some very attractive prices. The fund took advantage of some of those raisings to buy into good companies at attractive prices. Many of those raisings repaired good companies’ balance sheets and we have used that opportunity to buy into those companies.

What about recent IPOs?

The increase in initial public offerings activity has been a positive sign for the market. But as is similar with capital raisings, just because there is an increased activity does not mean that you should buy all companies. As always, you need to be very stock selective – as in the normal market, as with IPOs as well as with capital raisings.

What do you think of the banks and financial services sector?

Australian banks have done fantastically well through this whole environment, unlike a lot of their global peers. The fact that they have performed so strongly through the global financial crisis says a lot about the strength of the Australian financial system. 

Financial companies tend to do well in the first two years of a recovery. Given the already very strong performance of the banking sector I would tend to favour the diversified financials sector, as it offers some of the most attractive valuations and favourable growth prospects.

Is the Australian property sector offering good value yet?

We have maintained an under-weight position in the Australian REIT (real estate investment trusts) sector. We have been concerned with property fundamentals like capitalisation (cap) rates, rental growth and gearing levels. The market is still going through a cycle of higher cap rates, which means lower property valuations for office buildings, retail shopping malls and industrial properties. 

REITS have also been disadvantaged in a lot of the capital raisings, as they have been very dilutionary. In fact the main beneficiaries of these capital raisings have been the banks.

But I think we are getting close to the end of the cycle. We will start to see the end of the cap rate expansion and the end of weaker valuations in property through the December quarter 2009 and the March quarter 2010.  As we start to get to the end of the downgrade cycle the more I become interested in the REIT sector.

Do you hold any small caps?

The fund is not structurally biased towards smaller or larger cap companies; rather it seeks great investment opportunities and these are always present in both small and large companies.

Do you have a cap on the number of shares you hold in the Fund?

No, there is no specific cap on the number of companies held within the fund, although the optimum number of companies held should be between 30 and 50. Less than 30 companies is not a diversified portfolio, while holding more than 50 companies and the fund starts to get too close to the overall market and becomes difficult to significantly out-perform it.

How do you value companies?

There is not just one valuation metric. The best approach is to employ a whole range of valuation metrics, such as price to earnings ratios, enterprise value to ebitda (earnings before interest, tax, depreciation and amortisation), free cash flow yields, dividend yields and net present value analysis. Certain valuation metrics are more appropriate at different parts of the cycle. By undertaking a range of valuation techniques we can better assess the true value of a potential investment.