Bearish market: How banks, supermarkets and miners stack up

It may seem hard to believe at the moment, but astute investors can make money on the local sharemarket. This is despite the high volatility and the seemingly endless onslaught of gloomy economic news.

Investors who carefully select oversold quality stocks with resilient market-leading businesses, strong balance sheets and quality management should put themselves in an excellent position to really profit over the long term.

And, significantly, a range of these businesses pay high fully-franked dividends that should help sustain investors until share prices eventually recover.

There is, of course, a powerful caveat: investors venturing into this market should be prepared to cope with high volatility; their focus unquestionably should be on the long term.

In the Australian market, the most obvious stocks to assess for possible inclusion in a tough-time portfolio include, of course, the big banks, the big supermarket operators and the big diversified miners.

Should investors be increasing their holdings in these heavyweights at this time or is better value found elsewhere in other depressed stocks?

Big supermarkets

When economic times are tougher, the resilience of the big supermarket chains of Woolworths and Wesfarmers, owner of Coles, are highlighted. In short, these companies dominate non-discretionary grocery shopping.

“Supermarkets are attractively priced and offer more certain earnings growth and dividends than most industries,” says Andrew Doherty, head of equities for investment researcher Morningstar.

He emphasises that Woolworths and Wesfarmers benefit from efficiencies of scale and not an overly competitive market.

Morningstar forecasts that Woolworths will pay a grossed-up dividend yield (including the value of franking credits) of 6.71% for 2011-12, while Wesfarmers is expected to pay a grossed-up yield of 7.86%.

Dominic McCormick, chief investment officer of Select Asset Management, describes the big supermarket chains as the standard defensive stocks that pay out a high proportion of their income in dividends.

“But they are not excessively cheap because investors have been chasing them recently,” he adds.

“As long as investors are not expecting spectacular growth, it makes sense to have the supermarkets in your portfolio,” McCormick says. “Our preference is Woolworths.”

Prasad Patkar, portfolio manager with Platypus Asset Management, describes the large cap end of the market – the banks, diversified miners and supermarkets – as “pedestrian in terms of capital growth”.

However, Patkar adds: “Over the long-term when the equity markets re-enter a structural bull market, they [the banks, diversified miners and supermarkets] will make a lot of money for investors because they are good value now.” And, in the meantime, the banks and the supermarkets – but not the miners – are paying attractive dividends, he says.

Patkar warns that undervalued stocks can remain that way for some time before the market recovers.

Specifically regarding supermarket stocks, Patkar notes that the supermarkets are engaged in a costly price war that is lowering their returns.

Big banks

Morningstar estimates that the banks are undervalued by 26% and highlights their high dividend yields.

Andrew Doherty of Morningstar points to the big banks’ strong competitive positions, solid capital ratios, likelihood of “mildly positive” earnings growth, “weak but positive” earnings growth and control of costs. These positive factors, he adds, offset the higher wholesale funding costs and softening house prices.

Morningstar’s forecast grossed-up dividend yields (including the value of franking credits) for the four big banks in 2011-12 reporting period are ANZ (9.43%), CBA (8.71%), NAB (10.86%) and Westpac (11%).

Dominic McCormick of Select Asset Management says the grossed-up dividends of the big banks “clearly look attractive”. And he believes that the dividends appear sustainable in the medium term provided there is a soft landing in China and Australian house prices hold. “Thinking about the downside is worth doing because it highlights the risks,” he advises.

Select Asset Management’s “core view” is that China will experience a soft landing. “But a hard landing is not risk that investors should totally discount,” says McCormick.

Then McCormick raises the question: Where is the growth in the banks going to come from in an environment when credit growth is very slow and there’s pressure on both margins and fees?

“As long as investors are not expecting dramatic share-price growth, I think it makes sense to have a proportion of your portfolio in banks, he comments.

McCormick cautions investors about the risk of becoming overexposed to banks. “The trouble is that banks are such a big part of our market. If you are in a managed fund, you will have a big exposure to banks anyway.”

Prasad Patkar of Platypus Asset Management describes the big banks as good dividend payers and says they have limited prospects for capital growth until the market recovers. “This is fine for some investors,” he adds. “Their dividends appear safe – a housing bust doesn’t seem imminent.”

David Cassidy, chief equity strategist for UBS, says the earnings of the big banks are holding up reasonably well. And although expectations for market growth are lower than in the past, he points to the quality of the bank’s assets and their “robust” dividends.