Without an economic rising tide to lift all boats, only well-run businesses are going to outperform in the new economic "normal" growth environment.
Stock markets have delivered excellent returns for investors recently, but there is more juice in the stock market performance tank.
Lower global interest rates and expectations of a stabilisation in economic activity have driven stock markets up. New Zealand and Australian stock markets, while strong, have been battling declining earnings forecasts. Consensus market earnings forecasts were too high at the start of 2012 and were steadily cut over the year. Earnings growth forecasts are now more reasonable and may prove too conservative.
Many companies are restructuring to increase profit margins and free up cash from improved capital expenditure programmes. Stock earnings growth will benefit from these changes and a modest improvement in economic activity.
Local company debt levels are modest and balance sheet risk management is significantly improved following the global financial crisis. Companies are in better financial order to weather economic shocks than they were before the crisis. With balance sheet de-leveraging complete, companies are building up surplus cash.
Companies need to maintain stronger balance sheets than they did before the crisis but, given low economic growth, companies need to invest to grow. New investment projects will have to show they offer a superior rate of returning surplus cash to shareholders. While local stocks already offer a relatively attractive income yield, a steady increase in dividends and stock buy-backs are preferable to companies entering into new investments that don't stack up.
Companies may use the cash surplus to grow by merger and acquisition. To sustain returns to shareholders, firms will need to refocus on investment and acquisitions may be the quick fix. A number of industries are undergoing massive post-crisis changes, which will lead to industry consolidation. But while local companies may be the acquirers, they in turn look like juicy morsels to larger international groups. Corporate buyers will continue to privatise local listed companies where stock market investors are mispricing the underlying value of the business.
Both large and small investors are overexposed to fixed-interest (deposits and bonds) securities relative to where they should be long term. Long-term bond yields have fallen significantly over the past few years, producing strong returns for bond investors. Investors cannot expect to continue to receive such high returns from bonds. Local stocks are providing a high yield margin above fixed interest returns and provide a viable alternative for income-focused investors.
There are headwinds for stocks markets. Weaker economic tailwinds, structural change in many industries after the global crisis, and changing competition, regulations, taxation and technology mean companies need to work hard to stand still. Without an economic rising tide to lift all boats, only well-run businesses are going to outperform in the new economic "normal" growth environment. Many will under-perform, and some will fail.
Global events such as the US fiscal cliff will continue to batter investor confidence, but such events are part of the post-crisis rebalancing process and are masking an underlying stabilisation in economic and capital market conditions.
So while economies and capital markets are in a rebuilding/rebalancing phase, patient investors will reap attractive medium-term returns from investing in local stocks. To get through this phase, investors need to own a range of stock exposures that provide income, non-cyclical growth and leverage to a recovery in activity.
Local stocks look good in this environment. New Zealand and Australian stocks provide a mix of well-positioned companies, companies restructuring to meet change, defensive companies that can "weather the storm" and cyclical companies that benefit from even a modest pick-up in activity.
Shane Solly is head of equities at Mint Asset Management.
