10, 9, 8, 7, 6, 5, 4, 3, 3, 3… take off delayed…

As the 2013/14 year started, many of the headwinds that had been impacting Australian growth assets, particularly shares were starting to recede.  The fading mining boom was removing pressures on industry costs (particularly wages), interest rates had been cut to near record lows by the RBA facilitating a fall in the currency, and the looming federal election seemed set to remove the uncertainty of a hung parliament and an unpopular government.  Against this backdrop, the prospects of a significant rally in sharemarkets appeared good.

Certainly this was the case early in the year with markets rising strongly to be up 14% by October. However for the remaining eight months of the year, markets lost momentum and essentially finished at the same levels they started at in November.  While low interest rates provided the support for a flight to yield stocks, particularly retail banks, for the materials sector, decreasing cost pressures quickly turned from the glass half full to the glass half empty as investors focussed on moderating growth in China reflected in falling commodity prices.

So how do we see 2014/15 shaping up?

Investor focus will still be on yield as interest rates are forecast to remain at current levels for the year.  However, after such a strong performance in 2013/14, traditional sources of yield such as financials and utilities may not be the best place to look for shareholder returns.  Despite softer commodity prices and a stubbornly high Australian dollar we see increased cash flows in materials stocks such as BHP and RIO being distributed to shareholders as cost cutting and capital expenditure decreases while production increases.  For example BHP has increased iron ore production by 50% over the past three years.  This coupled with decreasing debt levels and an incentive to use accumulated franking credits before the decrease in the company tax rate means the likelihood of substantial capital returns is high.

Currently the price of the overall market as a multiple of estimated free cash flow in 2014 (an indicator of funds available for companies to return to shareholders via dividends or buybacks) is significantly higher for the market overall than for resource stocks such as Rio Tinto and Fortescue Metals.  As the chart below demonstrates since late 2011 the value of estimated cash flow for resources stocks compared to the overall market has steadily increased.

This trend looks set to continue to the point where the relative valuations are compelling.

This means investors can purchase these future cash flows much more cheaply in the resources sector.  Additionally should market forecasters prove too pessimistic on the medium term outlook of our larger trading partners, particularly China, investors stand to benefit from share price gains.

2013/14 showed yet again that market and economic forecasters are often susceptible to the latest occurrences or recent trends.  This can mean sometimes missing the next opportunity and can lead to chasing sectors or assets that are already priced for good outcomes.  It is important to look for opportunities that will pan out in the year ahead rather than focussing too much on the year that was.