When bears battle bulls

Australian investors can be forgiven for wondering - with some trepidation - what the sharemarket is going to get up to next. While the market has recovered some ground after falling almost 25 per cent in March from its October highs, it is still significantly down.

It may seem cold comfort to remind those living off their retirement savings that they have enjoyed five years of double-digit returns.

Australia's leading fund managers and market economists say investors should be prepared for at least another six months of volatility and perhaps longer.

"The worst is probably behind us but it is going to remain a fairly difficult environment for investors, unfortunately," says AMP Capital Investors' chief economist, Shane Oliver.

Many fund managers say the level of volatility in the Australian sharemarket is the highest they have experienced.

"The market is almost schizophrenic," says Stephen Croft, a senior investment manager with Portfolio Partners and leader of the fund manager's small companies team.

"It is going from periods of belated optimism to the depths of bearishness within months and then back again."

Lee Mickelburough, a Perennial Growth Management partner, says: "It has been the most volatile market I have seen in 20 years in the market."

And there are economic headwinds building that could well delay any recovery. Australia's economy is slowing and companies will be unable to grow their earnings at the same rate. Already some have begun to issue profit warnings and it is likely there are many more to come.

Then there are rising food and energy prices, which are helping to fuel inflation. Higher inflation is a drag on economic growth, corporate profits and the performance of equities. Inflation is at 4 per cent, above the Reserve Bank of Australia's target range of 2 to 3 per cent a year. The Reserve has already raised interest rates 12 times this cycle, to 7.25 per cent. The central bank will be hoping that inflation has peaked because it will not want to raise rates and dampen domestic demand any further.

Meanwhile, the resources sector is powering ahead as demand for commodities from China and other industrialising nations continues undiminished.

"What we have is a bear market in industrial stocks and a bull market in resource stocks," says Brian Eley, the co-founder of small companies manager Eley Griffiths Group. He says the difference between the two is enormous.

Most top-performing managers of Australian share funds have produced losses over the past year but have cushioned them by riding the resources boom.

BHP Billiton and Rio Tinto have been the mainstays for many of the top-performing funds. Both companies continue to benefit from the record prices being paid for most base metals, iron ore and coal.

Aquarius Platinum and oil and gas producer Australian Worldwide Exploration have performed well for Eley Griffiths. However, as with all mining booms, this one is attracting its fair share of speculative plays.

Eley says there are some very good projects and management teams but "unfortunately, there is also a lot of the other sort. So we do our best to step around them."

Han Lee, the founder of Prime Value Asset Management, has also done well for investors, with holdings in BHP Billiton, Rio Tinto and explosives and chemical maker Orica.

Fund managers have also seen good results from companies providing services to the mining sector. One of the best long-term performers for the Prime Value Growth Fund is Monadelphous, which provides engineering construction, maintenance and industrial services to the resources, energy and infrastructure sectors.

A $1000 shareholding in Monadelphous bought five years ago is now worth about $21,000. Lee bought shares in the company when it was relatively unknown.

Lee has a knack of identifying investment trends early. He has capitalised on higher food prices with investments in the Australian Wheat Board, ABB Grain and crop protection company Nufarm.

The Prime Value Growth Fund is one of the best-performing funds over the long term, with an average annual return of 22 per cent over the seven years to April 30 (see table).

"Like politics, investment is the art of the possible," Lee says. "You do as well as it is possible to do. Of course, everyone wants to maximise return for minimum risk. I try to get a satisfactory degree of return with an acceptable degree of risk."

But his good performance is due to more than just picking winners; it is also about avoiding losers.

"Avoiding them is just as important or sometimes more important than picking winners," Lee says. He avoided investing in stocks whose problems were triggered by the credit crunch, such as child-care services provider ABC Learning, property developer and financier MFS and Centro Properties Group.

OTHER SECTORS STRUGGLE

Apart from resources and agriculture, most other sectors of the market are struggling. Lee is underweight in the banks and in the financial services sector generally.

"The banks in Australia are in the business of selling credit to a country which has already borrowed so much that I do not know where the growth is going to come from," Lee says.

James Falkiner, the founder of Falkiner Global Investors (see box), has followed the Australian banking sector since 1986. He says the financial performance of the banks probably peaked three or four years ago, even though their share prices kept rising until late last year. The banks have struggled to get costs down.

As with Lee, Falkiner wonders where the growth is going to come from. "We have a heavily leveraged household sector," he says.

Fund managers also expect consumer discretionary stocks, which are down 35 per cent over the past year, to continue to suffer.

"Highly geared stocks with exposure to discretionary spending are to be avoided," Lee says.

"The wealth effect of the property boom made people feel like they could spend more."

Now that property prices are on the way down and food and fuel are up, he thinks consumers will spend less on things they can do without.

"We are trying to stay away from those areas," he says.

The share prices of some key consumer discretionary stocks such as Harvey Norman and JB Hi-Fi have almost halved during the past six months.

"The question is, are those stocks cheap enough to buy for the long term?" asks Bob van Munster, the head of equities at Tyndall Investment Management. "That is occupying at the moment."

Van Munster remains cautious on the sector, saying that the Australian consumer will continue to be hit.

"What we are finding is pockets of value in an eclectic bunch of stocks that has been bashed around for stock-specific reasons," van Munster says.

There is likely to be long-term value in building materials supplier James Hardie and gaming industry supplier Aristocrat Leisure, he says.

But James Hardie is exposed to the weak US housing market and, even though Tyndall already holds shares in the company, Van Munster says he will probably not pick up more until the problems in the US housing sector have bottomed.

Aristocrat Leisure's profit growth has been affected by regulatory problems in the US, its main market, and by the rising Australian dollar.

DEFENSIVE NO MORE

Normally, when markets turn bearish certain sectors can be relied upon to give some shelter from the storm. But a feature of this market is that the sectors usually regarded as defensive have been having a rough time too.

Listed property trusts used to provide shelter from stormy markets but have taken on a lot of gearing and have moved into funds management. Some have overpaid for properties at the top of the market.

Infrastructure stocks are usually another good bet in tough times but they have been leveraging up on cheap credit. This makes them volatile investment vehicles, even if the underlying assets are still defensive, says a BlackRock senior portfolio manager, Amos Hill.

US-listed BlackRock merged with Merrill Lynch Investment Managers in 2006. BlackRock is one of the world's largest investment managers.

BlackRock is finding growth and defensive characteristics in companies servicing the resources sector. Companies such as project development and contracting group Leighton Holdings have been huge beneficiaries of the resources boom.

They have been able to deliver earnings growth with a high degree of earnings certainty, says Mark Himpoo, BlackRock's head of Australian Equities.

BlackRock's Australian share funds feature strongly at the top of the performance league tables (see below). Himpoo says the key to outperformance over the long term is "to find business franchises with earnings certainty, strong management teams and clear strategies".

WHAT IS NEXT?

AMP's Oliver says the Australian sharemarket will probably remain weak because of the problems in the US but that the market could rally later in the year. The US economy is probably already in recession.

American banks and, to a lesser extent, European banks have had to declare losses totalling hundreds of billions of dollars because of the subprime lending crunch.

The other key factors for the Australian sharemarket are the Chinese economy and the extent to which Australian consumers will keep spending if the economy continues to slow.

However, the outlook for China remains strong, as does the earnings growth of Australian-listed resources companies, although earnings expectations for Australian industrial companies could still be too optimistic. "The market could be disappointed," Oliver says.

Some resource stocks are having a bit of pause at the moment, says Portfolio Partners' Croft. "But I cannot see that part of the market failing to outperform for long."

SHORT CUTS

For the year to April 30, the Falkiner Australian Absolute Returns Fund returned more than 13 per cent.

Over the same period, most other funds lost money, some more than 20 per cent. The fund is also one of the best performers over the long term, with an average annualised return of 26 per cent over the three years to April 30.

Falkiner Global Investors takes short positions in stocks, a way of making money when a stock price falls. But most of its returns come from the usual method of investing: buying stocks in the hope that their share prices will rise. By being able to invest short and by not seeking to mirror sharemarket indices, its funds can produce returns that are very different to the market.

The company was founded by James Falkiner in 2004. Falkiner, above, invests in the larger capitalised companies that have businesses he understands.

The best-performing stock held by the fund is Fortescue Metals Group. The share price of the Pilbara iron ore producer has more than doubled over the past six months. Fortescue was founded in 2003 by Andrew Forrest, who recently surpassed James Packer as Australia's richest man.