In more normal times, after a huge rally where the market has gone through its prior peak in just five quarters and the emergence of a new more virulent Delta variant of COVID-19 causing lockdowns across the Australian East Coast, you might be forgiven for thinking the market might pull back.
But these aren’t normal times.
Even though the economy expanded at an annualised rate of 7.2%1, the Reserve Bank of Australia has made it clear it won’t be lifting the official cash rate any time soon despite a clearly overheating property market. The federal government is still spending money to support the economic recovery, and bolster employment despite emerging signs of labour shortages. This leaves households with improving income outlooks, building cash balances and very cheap borrowing rates.
Just as importantly, companies are in a similar dilemma: we believe companies are cashed up, either because they raised capital last year which they eventually didn’t need; or because the economic rebound has been so much stronger than forecasted, and revenue has exceeded expectations. So now only a year after asking investors for capital in the face of an uncertain environment, companies now have too much capital on their balance sheets.
It’s likely that the boom in activity will end sometime, but not until the federal government stops spending money and the Reserve Bank starts increasing interest rates. And neither of those scenarios are likely in the short term. Only when the bulk of the population have received a COVID-19 vaccination, should officials start thinking about tightening policy. So, in the meantime, there’s a lot of pockets filled with hot money looking to find a new home.
Excess capital equals opportunity for investors?
In our opinion, next financial year will be a record for buybacks, and dividend payouts will be significantly higher than the 2021 fiscal year. We expect the banks to return an enormous tranche of capital2. The big miners are flush with cash from record high iron ore prices3. We expect there may be a large number of capital management programs, including share buybacks and higher dividend payouts over the next year, like the announcements we have already seen from Woolworths and Metcash4. This could set us up for a record year of shareholder distributions in this financial year.
Company executives have three options when cash is piling up in their zero-interest deposit account: invest in their business; distribute to shareholders; or buy a competitor/adjacency. Capital expenditure projects will pick up in mining where there are many upcoming projects in areas like battery minerals and potentially LNG5. But it’s in the M&A area where things are getting really interesting. We’ve already started seeing corporate buying off to a big start in 2021, and investment funds are now joining in.
The consortium of infrastructure investors, which included two local industry super funds, that bid $22 billion for Sydney Airport is the highest profile example6. A big price paid, for a trophy asset, but one where the outlook is far from certain and its monopoly is about to be ended by Sydney’s second airport being built in Badgery’s Creek. But there’s also activity in gaming, involving Tabcorp7, Crown Resorts and The Star8, and banking, with the majors offloading some of their non-core assets to simplify their businesses. There’s also corporate activity in the telecommunication, healthcare and property sectors, to name just a few. This creates a great opportunity for investors who may well end up with windfall gains from buyout premiums paid by these raiders. There are also opportunities for companies with unappreciated assets to sell them to these investors who seem happy to part with their money at what are now quite high prices.
Where is the sweet spot for the investors?
The mid-cap domestic names – the stocks outside the top 20 – provide an opportunity for capital growth and income growth. This is where we believe there could be bigger gains for investors. There are a bunch of domestic-focused stocks which are back to pre-pandemic levels with strong growth rates. Some of the mid-cap domestics names are getting a lot of operating leverage in our opinion.
When the market is awash with capital, you get a multiplier effect which the mid-caps may benefit from. There are parts of the market returning capital. That will primarily be the banks and big miners. Other parts of the market grow quickly as the economy rebounds. And companies with good cash flow, good balance sheets in attractive industries, are targets for acquisition.
For example, there’s opportunities in healthcare at the moment. We think there’s a multi-year growth pattern in a number of areas such as aged care and hospitals. A lot of the retailers are expected to grow, and we believe they already have too much capital.
In retail, we are expecting exciting possibilities. When people go back to the office, they’ll want new clothes, sometimes a size or two larger after lockdown. When people return to the football field, they’ll need new boots. And this extra revenue comes when retailers already have strong balance sheets and no debt.
As I said at the beginning of the story, in normal times we might lighten up on equities and get a bit more defensive. But these aren’t normal times.
We believe companies and households are awash with capital. It’s burning a hole in the pockets of company execs, new investors and boards. In many cases they are happy to go out and use that money. Activity begets activity and while index levels and earnings estimates have returned to pre-COVID levels, don’t be surprised if the market grinds higher and you wake up some mornings with a new corporate raider looking to pay you 20-30% more for some lucky stock in your portfolio. In our opinion, now is the time to stay level-headed in your investments and let others bring the heat!
1. Australian Bureau of Statistics (ABS): Australian National Accounts: National Income, Expenditure and Product - March 2021
2. AMP Capital, FactSet. As at 16 June, 2021.
Subscribe to SMSF News using the form below to receive all of my articlesDermot Ryan, Co-Portfolio Manager (Income)
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