Vacationers know her beaches and coral reefs. Wine connoisseurs know her vintages. But few investors seem to know the advantages offered by Australia and its remarkably resilient economy.
Dollar-based total returns of Australian shares have consistently outperformed developed equity markets across the globe. Through November 13, MSCI reports the Australian market soared 95% in 2009. No other market did better. The same holds for the trailing three years, with Australian stocks averaging annualized returns of 7.49%. Five-year annualized returns of 14.04% were bested fractionally only by Spain. Over the last decade, Australian stocks again led the way, averaging total returns of 13.99%.
Despite the current strong rally, both the MSCI US and EAFE indexes pale miserably over the comparable period.
Domestic 1-, 3-, 5-, and 10-year annualized returns were 23.93%, -5.27%, 0.74%, and -0.64%, respectively. Foreign market returns weren't much better: 43.57%, -3.79%, 5.38%, and 2.84%.
As a source of secure income, Australian commonwealth sovereigns, AAA-rated government bonds, have traditionally yielded several percentage points more than U.S. Treasuries across the yield curve. As of mid-November, Australian yields were collectively averaging 5.43% versus U.S. yields of just 3.02%, according to the J.P. Morgan Overseas Government Bond Index. There is a huge spread in short-term yields. One-year Treasury notes were yielding a mere 36 basis points; Aussie Sovereigns due in eight months were yielding 4.25%. Venturing into AAA-rated state bonds gets you an additional 50 basis points, and AA-rated corporate bonds up to another 150 basis points.
Further supporting these opportunities is a currency that's been steadily appreciating against the dollar for a number of years. Since getting knocked back by the unexpected dollar rally at the end of 2008, the Aussie dollar has rallied 50% against the greenback over the past 12 months through November 13. For unhedged investments in Australian securities, that appreciation went straight to the bottom line.
"Australia's economy has been broadly protected from the economic storm raging in the rest of the world," reports the Economist Intelligence Unit. While jobs have been disappearing at an alarming rate across many developed markets, Australia's unemployment rate of 5.7% has increased by only 1.5 percentage points over the past year and has remained flat since June.
EIU reports that house prices in Australia have barely budged from historic peaks in 2007. With virtually no subprime exposure and loan arrears remaining small, the country's banking system has held up well, having remained profitable throughout the financial crisis, enabling lenders to stimulate growth.
"Most important," notes the EIU, "the country's trading position with Asia, and especially China, is flourishing. China, where growth is booming again, is now Australia's largest trading partner. Exports of raw materials have grown from 20% of Australia's exports to more than 40% in the past decade."
All of these factors have helped the economy avoid recession. It expanded 2.4% in 2008 and is projected to end 2009 having grown by 1.0%. That will mark the 17th consecutive year of GDP growth that's been averaging well north of three percent annually. "That defies statistical logic," observes Derek Izuel, manager of Highmark Capital's Core Equity fund, with more than a decade of experience managing global portfolios. He believes there hasn't been a reversion to more earthbound averages because Australia is an atypical market.
"The country is unique-a huge, mineral-rich, economically diverse land mass hosting a small population of just 22 million people that's complemented by well-capitalized banks," Izuel says. Four of the world's large AA-rated banks are Australian. Izuel says that the country "enjoys [a] strong corporate governance and regulatory environment that support an efficient, established marketplace."
Another compelling aspect of the country is its competitive standing globally. In its latest review of the quality of the business environment, the EIU ranked Australia seventh, six notches ahead of the U.S.
Reflective of the government's growing confidence that the economy has weathered the storm, the country's central bank, the Reserve Bank of Australia, has been raising interest rates. After having eased monetary policy from 7.25% in March 2008 to 3% in April 2009, the RBA was the first developed market central bank to start pushing rates up: 25 basis points in October and again in November.
Despite all of the country's positives, most globally diversified investors have only limited exposure to Australia. Advisors who have purchased the international index, EAFE, have provided clients with only 8.23% exposure to Australia. When relying on the MSCI All World Country Index, exposure falls to 3.31%.
Stocks
The Australian stock exchange is dominated by three sectors: Finance represents 27.5%, materials 22.9%, and consumer staples 14.2%. Within these groups, Australia has a number of industry leaders, many of which trade in the U.S.
BHP Billiton is the world's largest and most diversified resource company. It produces petroleum, aluminum, copper, gold, iron ore, coal, nickel and diamonds. Its earnings and stock price have been growing at a nearly 30% and 26% annual clip, respectively, over the past five years. The current PE is 18. According to Morningstar analyst Mark Taylor, keys to BHP's success are its low-cost operations, a strong balance sheet and operations that are based in the relatively safe havens of Australia, New Zealand, North America and Europe. He believes the company is an ideal way to play the economic recovery and the accompanying rise in commodity prices.
Macquarie Group is one of the world's most innovative investment banks. With a focus on infrastructure, the bank specializes in buying assets around the world and setting up specialized funds that eventually hold them. While shares got slammed by the banking crisis, they've rebounded close to their 52-week high. The reason, explains Morningstar analyst Peter Warnes, is that the bank has been free of unusual provisions or write-downs. It hasn't been exposed to problem trading or poor credits. Macquarie's "risk policies are closely aligned with those of Goldman Sachs, which has provided added confidence in its management and risk policies," he says.
Macquarie's average earnings growth rate over the past five years has been running north of 22%, with annualized price returns of more than 10%, and a current PE of 16.5. Investors enjoy a 4.7% dividend.
Australia also has strong commercial banks: Australia & New Zealand, Commonwealth Bank of Australia and Westpac. They have generated annualized net income growth near or into the double digits over the past five years and pay dividends exceeding 4%. Their stock prices have all appreciated from 8% to more than 11% annually over the last five years. Rich dividends have pushed these returns even higher. After investors dumped shares indiscriminately during the height of the banking crisis, these shares have all rebounded near their 52-week highs.
Woolworths Limited is known as "Wal-Mart Down Under," and it might be even better than the U.S. retail giant. Its shares barely budged during the crisis. Annual earnings, dividend and stock price growth has averaged more than 16% over the past five years as the company continues to thrive. Warnes describes Woolworths as a "growth stock with significant defensive qualities, possessing a strong balance sheet and a wide competitive moat characterized by extensive supply chain operations and intimidating buying power." And it offers a 3.8% dividend to boot.
Healthy dividends are a trait of Australian stocks, which is why they are the second-largest holding in the ING International High Dividend Equity Income Fund. The country represents 12.5% of manager Martin Jansen's portfolio. But he is keen on Aussie shares not just because of high, sustainable payout ratios, which are around 15 percentage points above U.S. standards. "Substantial distribution of profits to investors demands a greater discipline in the use of remaining capital and certainty about rates of returns on new investments, which has been confirmed by academic research that reveals that these stocks tend to have lower betas and volatility over the long run," Jansen says.
Bonds
While carry-traders venture into emerging markets like Brazil to capture higher interest rates, Australia is likely a safer way to increase income by hundreds of basis points over U.S. Treasuries. As of November 20, according to Sydney-based Citigroup senior economist Josh Williamson, Australian Commonwealth Government Bonds due in August 2010 were offering yields to maturity of 4.12%. April 2012 sovereigns' annualized returns are 4.74%. State bonds, like those issued by New South Wales, were paying even more-5.07% for May 2012 issues. "Investors can be rewarded even more by going out longer," remarks Williamson, "but with interest rates likely to be trending higher over the next year, investors may be better served staying short-term and rolling over proceeds into perhaps subsequently higher yielding bonds."
"AA" rated corporates can deliver even greater yields with only marginally greater risk. Citigroup's Australian credit strategist, Mark Reade, points to ANZ National Bank's September 2010 bonds that have a YTM of 5.1%, its March 2011 offering that delivers nearly 5.5%, and Westpac's June 2011 issue that's returning 5.9%.
A weakening Australian dollar versus the greenback is the significant risk in these plays. But with Australia's solid macroeconomics and the Reserve Bank of Australia already in a rate-tightening mode, most currency analysts see a greater likelihood of the Aussie dollar strengthening, which would add to U.S. investor returns.
Funds
Investing in a market-cap weighted index of the Australian market has been a simple, liquid and inexpensive way of capturing the country's equity performance and alpha beyond traditional international equity exposure through EAFE. An investor can purchase the iShares MSCI Australia ETF at the same cost as ordinary stock. The ETF passes on a tax-qualified dividend that's currently above 4%, and its annual expense ratio is 52 basis points.
Three-quarters of the performance of this $2.4 billion fund is driven by materials and resources (41%) and financial services (34%). It's top five holdings are BHP Billiton (14%), followed by the country's big four banks-Commonwealth Bank of Australia, Westpac, National Australian Bank and Australian and New Zealand Bank, which comprise nearly 30% of the fund.
Through November 20, the ETF soared more than 127% over the previous 12 months, outperforming EAFE by 74.47 percentage points. Three-year annualized returns were 6.24%, outpacing the benchmark by nearly 11 percentage points. Five- and 10-year annualized returns were each slightly over 12%, outperforming EAFE by 7.77 and 10.19 percent points, respectively.
Philadelphia-based Aberdeen Asset Management offers the only actively managed portfolio, marketed in the U.S., that provides pure exposure to Australian stocks. The Aberdeen Australia Equity Fund trades on the American Stock Exchange and has been outperforming the Australian MSCI benchmark.
The fund's liquidity differs from the iShares ETF. It has smaller daily trading volume that averages about 61,000 shares. Because it is a closed-end fund, investors are not buying shares of the underlying stocks at their net asset value but at what the market values the fund. This produces a variable when purchasing and selling fund shares, as well as in measuring performance.
According to Morningstar, the fund's market price has generally deviated from its net asset value by as much as 10% since 2005. In November of 2008, when investors were fleeing stocks, one could have purchased the fund at a 9.56% discount to the worth of its shares. A year later, the fund's market value was actually 10.29% above the value of its portfolio, having temporarily spiked to nearly 20%.
The fund's composition is a bit more diversified than the MSCI Index, with industrial materials making up 32.5% and financials 26.1%. Its top five holdings, also representing more than 40% of the fund, are also different. While it's topped by BHP Billiton (14.65%), manager Mark Daniels also has an 8.19% position in Rio Tinto, Australia's other major resource giant. QBE Insurance represents 6.48%, followed by Westpac (6.31%) and Woolworths (5.30%).
The fund, which has a 1.47% annual expense ratio, had a 1-year return of 168.29% through November 20, exceeding the MSCI Australia index by more than 40 percentage points. Three-year annualized returns were 6.94%, topping the local benchmark by about 70 basis points. Five-year and 10-year annualized returns of 14.11% and 14.57%, respectively, topped the domestic index by more than two percentage points. Inclusive has been a dividend that's currently near 4%.
Australia has a number of local investment trusts that are equivalent to U.S. mutual funds. They trade only in Australia, but several can be purchased directly by U.S. investors. Wilson HTM Asset Manager, for example, which runs more than A$8 billion, started its small-cap focused Priority Growth Fund in 2005 and has seen its assets grow to A$100 million on the back of 3-year annualized returns in local currency terms of 23.3% through October. The minimum investment is A$40,000, its management fee is 1.25%, and it levies a performance fee of 20% annually on profits above the S&P/ASX Small Ordinaries Accumulation Index.
Tim Murphy, co-head of funds research at Morningstar Australia, cites two large-cap funds with solid long-term track records that are also open to foreign investors. The A$3 billion Ausbil Australian Active Equity Fund has generated 10-year annualized returns of 12.38% through October. The minimum investment is A$50,000 with a management fee of 90 basis points. Ten-year annualized returns of the A$1.2 billion Schroeder Australian Equity Fund are 11.24%. The minimum investment is A$500,000 with a management fee of 57 basis points. These two funds don't collect performance fees.
Despite a significant swoon in the Aussie dollar late in 2008 as investors flocked to safe-haven currencies, performance of the fund has been impressive over its brief trading history. Over the past year, the fund was up 47.20%. That was nearly triple of what Deutsche Bank U.S. Dollar Bear Index, a basket of six of the world's most widely traded foreign currencies, delivered over the same period, which was up 17.52%. And over the past three years, the Aussie Dollar fund averaged annualized returns of 11.96%, besting the foreign currency basket by over eight percentage points.
Investors also benefit from the structure of the Trust, which keeps assets in demand deposit accounts, which is currently yielding 2.27%.
Australia is not a panacea for market risk. As was seen last year, the country is vulnerable to global economic volatility. While the current rally is a symmetrical response to a severe sell-off, profit-taking and a correction are likely over the near term. The same holds true about the rapid rise of the Australian dollar. Currencies don't move in only one direction. And when U.S. interest rates start to rise, traders may respond by supporting the greenback. Until then, prolonged appreciation of the Australian dollar could erode the country's export strength and foreign direct investment in Australia.
But the rapid recovery of its equities and currency speak of Australia's underlying strength. With most market observers believing that emerging markets are going to be the strongest sources of growth going forward, achieving this exposure through the security of a strong developed market may be the safest way ahead.