Resources boom to prove prospects

THE Australian sharemarket is bloated with investor optimism in the midst of an unprecedented resources boom but 2006 is the year it will need to prove itself.

That's the view of some of Australia's top fund managers who cannot agree on whether resources will soar, simmer or subside this year. Nor can they find any common ground when it comes to which stocks will be the star performers in the coming months. They are, however, united on what to avoid and say it will be a year for the well-informed stock picker.

The Herald's panel of fund managers have come up with a selection of companies they believe will stand out in 2006, as well as some general comments about what is broadly expected to be another strong year for Australian equities.

"The earnings growth for the market in the last couple of years has been pretty near 20 per cent and Ö a fair chunk of that growth has been resource-related," ABN Amro Asset Management's portfolio manager, George Clapham, says.

"The Australian market's earnings will come back to a more normal rate of growth in the back half of 2007. The outlook for the domestic sharemarket is probably less appealing than it has been."

With fund managers forecasting a more subdued market, investors will need to make more careful decisions this year.

"We still think there is some value in a number of companies but you have to be really selective this time around," AMP Capital portfolio manager Tony Oesterheld says.

The price/earnings ratios - a measure of how expensive a stock is relative to its earnings - of many Australian companies have soared with the bullish market conditions and they will be under scrutiny next year, Oesterheld says. "These high PE ratio companies will need to deliver to keep their ratings."

Oesterheld is monitoring a number of high PE stocks, including the rapidly expanding health companies ResMed, Cochlear and CSL, and the "hefty PE premium" industry stocks AGL and Foster's Group to determine whether they can deliver on their ratings.

Investors Mutual portfolio manager Andrew King is also scrutinising individual stocks to make sure they are not overpriced.

"We are very cautious that the market isn't factoring in too much earnings growth [in current share prices]," he says.

Clapham says investors will increasingly look towards global equities as an alternative to the Australian sharemarket. "International equities have come down in value," he says.

This view was strongly supported by a Russell Investment Management report which stated that two-thirds of Australian fund managers are now expecting international equities to outperform domestic stocks, listed property trusts and bonds over 2006.

But the billion-dollar question remains: how long will the resources boom last? And this is where the opinions of fund managers really start to diverge.

"We think that story will stay for some time, at least another two years plus," Oesterheld says. Underlying demand is so strong it will take supply a while to catch up, he adds.

However, Clapham has a different outlook. "Looking at commodities - we are at high levels. Are they going to go higher? My view is probably not so that it will have an impact on earnings which will start to be recognised in the second half of 2006."

Dean Fergie, portfolio manager at Opis Capital, says: "Commodities have had a very, very, very good year and that would be unlikely to be repeated."

But the one thing fund managers agree on is that 2006 is the year to avoid companies that rely heavily on consumer discretionary spending.

"There have been high levels of debt-funded consumption so any domestic interest rate rise will have quite an impact on the consumer and property prices, so that's a major pressure," Clapham says.

King says this will particularly affect retail property and building stocks and discretionary retail.

The key message is that after two years of higher-than-expected gains, investors should approach the market with some caution.

"A lot of businesses have seen very, very strong growth and been operating in a buoyant economy so be careful about any over-exuberance from companies about their prospects next year," Fergie says.

ANDREW KING, Investors Mutual, portfolio manager:

Sky City Entertainment Group: It's [a] well-managed gaming casino and it could benefit from any consolidation of the industry. More importantly, it is attractively priced at current levels and has got strong strategic assets such as its Auckland casino.

Prime Television: It is a well run regional television operation affiliated with Channel Seven.

They have exited their loss-making NZ venture, which will be beneficial for shareholders. And it is going to benefit on the back of Channel Seven's rating success this year.

Ansell: It is well run and has globally diverse businesses in different market segments with operations dotted throughout Europe, Australasia and North America. It has a healthy balance sheet and is either No.1 or No.2 in its business segments globally.

Connect East Group: A [yet to be finished] toll road from Scoresby down to Frankston in Victoria. It is internally managed so there are no external management fees like the infrastructure funds and we think over time it will be a good asset for users and investors - along the lines of Transurban.

GEORGE CLAPHAM, ABN Amro Asset Management, head of Australian Equities

Woolworths: It has got good defensive attributes and its positioning in food retailing is second to none.

It's got the potential to develop significant businesses in both New Zealand and the liquor market in Australia. Its cash generation is superior to most companies.

Brambles: The company is downsizing to its two core growth businesses, which sustain strong competitive advantages. The divestment of other businesses will result in significant returns of capital to shareholders and it will have a very strong financial position even after returning significant capital.

Orica: Exposure to the mining services industry set the company up for increased rates of growth as the mining industry expands production to meet increased demand for commodities.

Orica increased its exposure to mining services through a significant acquisition in 2005, which has strengthened its competitive position.

Austar United Communications: It is Australia's only profitable pay television company with a dominant presence in regional Australia, which is an under-penetrated market. A selldown by a private equity group has improved the liquidity and potential investment appeal from the broader market.

TONY OESTERHELD, AMP Capital, head of the value plus funds team

Harvey Norman: In 2006-07 they'll do well with growth coming from some of their overseas operations. Their strength relative to a number of their competitors will be quite an advantage in a difficult retail environment.

Alchemia: They are a manufacturer of a synthetic Heparin program. A lot of the technical risk is coming out of the company and they have got a marketing partner in the US. The patent on the branded drug runs out this year so it will be interesting for the longer term.

We think biotechs are something to keep an eye on given they are under-researched in Australia.

News Corp: Its balance sheet is in good shape and its free cash flow is very good. Going out a couple of years it is looking good at the current price. We think the market has been a bit distracted by the company going out of the index and some of the corporate governance issues.

Origin Energy: Its strategy of many years has set it up really well. They've got some contributions coming in from Bass Gas and they've also got the Otway gas project [in South Australia]. And the amount of free cash flow that will be coming out of it in the next two to three years.

DEAN FERGIE, Opis Capital, portfolio manager

MFS: They are providing a range of different investment products through income funds. They own a majority stake in a fund of funds called HFA [Hedge Funds of Australia] and they are providing a lot of different types of investments through other exposures, including a golfing fund and an interest in Falls Creek and Mount Hotham.

They are seeing really good growth in funds under management.

Timbercorp: It provides a newer range of investment products: they have set up almond plantations and olive groves. They get fees for setting up the projects and managing them. A lot of people have made money out of equities and property, and this is an option to have exposure to agriculture.

PCH Group: The main business is providing scaffolding so they have got a pretty strong presence in north Western Australia where they provide scaffolding to oil and gas explorers. They've had two or three years of very, very strong growth because demand for construction and maintenance is continuing to grow.

Seek: Its only business is online job classifieds and it has [a] dominant market share. People go there because people go there [both job seekers and employers] - you've got almost an Ebay model. They've been growing at 50 per cent over the last few years and we think that is sustainable for the next three years.