Australasian Shares - Highly Priced or will it be slow growth ahead?

Another quarter has all but gone, and share markets have had there ups and downs, but the overall trend has been upward.  We get asked questions about shares, and invariably the comments are that Australian and New Zealand shares are overvalued.  Should I be selling? Or should I be switching to International shares which have higher allocations in your portfolios?

Let’s focus on the long term outlook for Australian shares, looking separately at resources and industrials earnings growth.  New Zealand shares are also unattractive, at a PE of over 19 times earnings.  With just modest growth prospects, this makes the New Zealand market look expensive.

Valuation measures are not reliable indicators of short term market behaviour.  Markets can stay overvalued for years.  A twenty percent fall in Australasian share prices would be nasty, yet still be quite modest by historical bear market standards.

If we look at forecast returns for other asset classes, there may be a 1.5% to 2% benefit per annum, but even a relatively small forecasting error may negate the benefit altogether.  To be confident of obtaining a benefit from switching between two asset classes, there should be a difference of somewhere between 3% to 4% pa difference.

Never the less, some profit taking will probably be in order for some investor’s portfolios, and it would probably be prudent not to take on any additional investment risk, as it is unlikely to be beneficial.

How fast can companies grow their earnings? Earnings growth over the next decade is likely to be slower than what it has been over the last decade.  This slower growth will lead to lower returns.  In the long term (20+ years) earnings per share growth rates tend to lag GDP growth by 1% to 2% per annum.  If earnings grow at the same rate as the economy as a whole, then earnings per share will grow a little slower than GDP because new shares are continually being issued through new share floats and capital raising by existing companies.

Since 1990, companies have been growing their earnings much faster than GDP through improvements in productivity and better capital management.  Over the past decade Australian companies have grown earnings by 10.4% per annum, which is twice the rate of GDP growth.  Going forward with lower rates of expected GDP growth, earnings per share growth could be below 4.2% per annum or less than half the rate that has occurred since 1990!

Competition is moderating profitability and earnings growth.  It is logical that high profitability will attract capital investment and competition, leading to oversupply and falling profitability.  Free trade encourages it.

There is a view that Australia’s proximity to Asia will ensure that the earnings boom for Australian shares will continue for many years.  For this to happen, the extra growth will have to come from those companies that are the beneficiaries of the resources boom, being the resources sector.  But the market has not really factored that in with resources stocks averaging 13.7 times earnings compared to 18.7 times earnings for industrials.  It appears that the view in the broking community is that the increase in production by resource companies will be accompanied by fairly steep falls in the prices of commodities as the increased production comes on line; hence they see only modest earnings growth.

If in fact the resource sector generates a boost to overall market earnings growth then the resource sector will be outstanding.  It could prove to be an uneven game and a difficult one to call.  Perhaps it is an area best left to the experts.  With the changes in the tax rules, and advent of PIE’s there will be no advantage to try and do it yourself.