No one should ever think there's a single way to beat the market. Portfolio diversity is essential. But if there currently is anything close to a magic bullet, it might very well be the market down under. The Australian economy has been on a tear ever since Clinton was in the White House. And this has translated into remarkable returns for investors.
Over the last decade through November 2, total annualized returns of the MSCI Australia Index have increased at a rate of more than 15% a year in local currency terms. That's 832 basis points a year better than the MSCI U.S. market. When measured in U.S. dollar terms, Aussie stocks have outperformed the states annually by a staggering 1,139 basis points, returning more than 18% per year.
Same story over the near term. Trailing one-, three- and five-year annualized returns of Aussie stocks have doubled those of U.S. shares in local currency terms and tripled U.S. returns over each of these periods when measured in greenbacks.
A strengthening Aussie dollar has helped. Since 1997, the local currency has appreciated by 2.83% a year. But more recently, the Aussie dollar has generated tremendous upside for U.S. investors shipping capital down under. Five-year annualized appreciation has exceeded 10%, and over the last year the currency has soared nearly 20%. Nearly half that run-up occurred over the past three months as the dollar's gradual depreciation has morphed into a tailspin.
But Australia offers more than profitable short dollar exposure. Unlike any other economy, Australia has enjoyed 15 years of uninterrupted positive GDP growth, expanding at an annual rate of 3.63%. This trend has supported a remarkable 12-year run of job increases, which looks likely to continue. The Economist Intelligence Unit projects the economy will grow by 3.9% in 2007 and 3.2% in 2008.
Some fear the Labor Party's recent defeat of Prime Minister John Howard, a free-market advocate who helped liberalize Australia's economy during his 11 years in power, could make the nation less friendly to investors. Most experts doubt this. "We did a study of past Australian elections and found that they didn't appear to influence Australian equity markets the way U.S. presidential cycles seem to," says Morgan Stanley's Toby Walker, who is more worried that Australian equities, on a technical basis, may have gotten a little ahead of themselves. "We believe that the major issues facing investors with regards to Australia will be unaffected by the election outcome."
Throw Out Benchmarks
Protracted growth like Australia's defies statistical logic. Derek Izuel, senior portfolio manager of the $560 million AIM Global Equity Fund, believes that there hasn't been a reversion to more earth-bound averages because Australia is an atypical market where even severe drought hasn't slowed things down.
"The country is unique-a huge, mineral-rich, economically diverse landmass hosting a small population of just 20 million people," explains Izuel, "with well-established markets and banking system, strong corporate governance and regulatory environment that support an efficient marketplace."
No surprise then that Izuel's exposure to Australia [6.65%] is twice the weight of MSCI's Global Index. He has a heavy preference toward the country's banking shares, which are, themselves, a broad proxy for macroeconomic exposure. This has helped the fund generate five-year annualized returns of 18.54% through November 5-169 basis points greater than the MSCI World Index.
Thomas Burke, portfolio manager of the $890 million BlackRock Global Growth Fund, believes responsible fiscal policy has also helped the country sustain its record growth rate. The International Monetary Fund recently reported that the "government has recorded surpluses in nine of the last ten years, and net government debt was eliminated in 2006."
The Reserve Bank of Australia continued to tighten monetary policy despite the current federal election campaign. This move in early November nudged interest rates to an 11-year high of 6.75% in response to continued inflationary pressures. This is in contrast to the less restrictive posture taken by the U.S. Federal Reserve and European Central Bank, which are more focused on liquidity concerns stemming from the current mortgage mess.
The country has enjoyed a long-term housing boom of its own, and one would surmise that it, too, could be vulnerable to lending excesses and the import of troubled mortgage derivatives. But according to central bank governor Glenn Stevens, the fallout from subprime has simply been less pronounced in Australia.
Burke adds that growth has also been hyper-charged by the country's proximity to the world's fastest-growing region-Southeast Asia. "While the case for investing in Australia has stood on the its own merits," says Burke, "the market has become a proxy for more secure, regulated access to some of the world's fastest-growing emerging markets, especially China."
Burke's 12.2% Australian weighting is the highest of any diversified global fund manager and is among his largest country holdings, second only to his U.S. position.
As of the beginning of the year, Australia represented 22% of the fund. Burke explains that this was the result of "regular incremental additions to our portfolio, based on bottom-up analysis, enhanced by phenomenal growth." He has since decided to lock in profits and rebalance his portfolio more defensively.
Still, his 23 Australian investments remain tantamount to an independent country fund, with holdings in energy, financials, health care, industrials and materials. They have helped the fund produce a trailing 12-month return of 46.58% and a five-year annualized return of 22.51%, 566 basis points greater than the MSCI World Index.
Burke is concerned, however. If "China sneezes, even a mature market like Australia will shutter." But overall, he says, Australia is in the enviable position of benefiting from, rather than competing against, Chinese expansion.
More Positives
The Economist Intelligence Unit recently ranked Australia No. 8 above the U.S. No. 9 in terms of the quality of business environment. This study, which measures sentiment for the next five years, considers macroeconomic imbalances, trade liberalization and protectionism and the quality of infrastructure, along with security risks.
Another benefit of Australian equities is the company managements' commitment to distributing excess earnings to shareholders. The market's current yield of 3.42% is more than 60% higher than the global average of 2.16% and twice the U.S. yield of 1.79%, according to FTSE.
Bank shares are especially attractive sources of income. U.S.-traded shares of Australian and New Zealand Banking Group (ANZBY), Commonwealth (CBAUY) and Westpac (WBK) perennially yield more than 4%. Their payout ratio (percent of earnings paid as dividends) is around 70%. Yet this hasn't impeded growth, as shares have surged by an average annual rate of 25% over the past five years in U.S. dollar terms.
While bank stocks in the west have stumbled through the fallout of the current credit crisis, Aussie bank prices have rallied on. And UBS Australian banking analyst Jeff Emmanuel believes that the overall environment for industry earnings remains healthy.
Australia's dominant investment bank, Macquarie Group, is also one of the country's unique plays, with half of its funds dedicated to global infrastructure such as highways and airports. As the preeminent player in this field, it has been shielded from the current market turmoil while continuing to achieve top- and bottom-line growth.
Since it started trading in the U.S. in the middle of 2005, Macquarie's shares have surged 74% through early November and they currently pay a 4% dividend. Morgan Stanley's Asia-Pacific analyst Richard Wiles is overweight in the stock, believing the market is currently pricing it for a worst-case scenario. He thinks this is a mistake considering the group's growth profile: Its specialist fund business model, niche offshore growth opportunities and higher relative exposure to the Asia-Pacific region, says Wiles, sets Macquarie apart from most other investment banks.
Aussie shares have also been fueled by a run-up in deal making. Since merger activity bottomed in 2002 with 1,361 deals worth $3.4 billion, M&A has more than quadrupled in dollar terms during the first 10 months of 2007 with 2,454 mergers valued at nearly $155 billion, according to Thomson Financial. And this value could double if BHP Billiton is able to convince its domestic mining competitor Rio Tinto to agree to its $140 billion merger to create a global industry leader.
A Caveat And A Play
A cautious voice about venturing down under at this time can be found in Morgan Stanley's Australian analyst Toby Walker. In a recent note, he downgraded his view of local equities to "neutral" because stocks have shot up past his price targets. "With the market's 12-month forward P/E at 16 times 2008 earnings," he believes, "valuations have nowhere further to go."
He sees evidence of additional headwinds ahead. These include rising inflation and capacity constraints that could lead to additional interest rate hikes by the RBA, along with corporate earnings that could come under pressure from the soaring Aussie dollar and slowing growth in the developing markets. Walker is concerned that these issues could collectively restrain forward sentiment toward Australia.
But the country has been living with these risks for several years, and still her markets have surged on the back of strong fundamentals. And Walker acknowledges this by remaining overweight in banks-the most direct reflection of the country's economic fortunes-because of their attractive yields and double-digit earnings estimates for 2008.
Advisors can gain substantial bank exposure along with access to the rest of the Australian market through Barclays Global Investors' Australia iShares (EWA) and the Aberdeen Australia Equity Fund (IAF). EWA tracks the MSCI Australia Index, and delivered a ten-year annualized return of 17% with annual expenses of 56 basis points. IAF is an actively managed closed-end fund, with minimum turnover, trading at a modest discount of 1.36%. Its ten-year annualized return is 19.76%, with annual expenses of 1.62%.
Commodities and banks need to do well for these funds to pay off. However, George Evans, director of international equities at Oppenheimer Funds in New York, believes the appeal of Australia goes beyond metals and finance. "The country's strong macroeconomics, exceptionally well-run corporate sector and diverse range of industries make Australia one of the most compelling markets around," says Evans.
Certainly past performance doesn't assure us anything. But the country's track record and prospects make it hard to argue with Evans.
