Private credit might be less attractive than it was last year as investors rush into the market, but there are sweet spots to be found.
For three years running, AustraliaÆs retirement funds have clocked up double-digit gains. In 2006 the median gain for the 50 largest funds was 13.6% thanks largely to record dividend payouts and a rash of leveraged buyouts that pushed up the local stock market. Buoyant global markets helped too, particularly in December, when super funds added 2.1% in one month alone.
Aussie funds have a high proportion of their assets in equities, accounting for almost 60% of total investments. More surprisingly, almost half of this is invested at home, with the average fund holding 30% of its total assets in local stocks. ThatÆs a lot when you consider that, in global benchmarks like MSCIÆs, AustraliaÆs weighting fluctuates between 1% and 2.5%.
This fondness for local equities has created a symbiotic relationship between issuers and investors in Australia that makes it easy for companies to raise money. Each year there are several large listings that are effortlessly absorbed by local funds. In 2004 it was a A$1.1 billion block trade of Qantas shares and a A$1.3 billion IPO for clothing manufacturer Pacific Brands; in 2005, a A$2.12 billion offering by food conglomerate Goodman Fielder; and then last year a massive A$15 billion placement by national telco Telstra. In a lot of these transactions, local funds are scaled back to allow foreign investors to participate and improve diversification for the issuer.
But if what equity analysts are predicting comes true, 2007 could see a seismic shift in this demand and supply balance. They say that the number of new IPOs and secondary equity listings will be well outweighed by the influx of savings flowing into the system. ôOur research shows that there will be an equity shortfall of A$44 billion this year,ö says Adnan Kucukalic, Australia strategist at Credit Suisse. ôThat means A$44 billion in savings that has no place to go if weightings in Australian equities remain as they are.ö
The excess demand is coming from a number of sources other than the standard 9% compulsory contribution and the money returned to the system from dividend payouts and share buy-backs (see chart). KucukalicÆs breakdown shows A$3 billion flowing from pension holders taking advantage of a one-off opportunity to inject a lump sum into their funds without incurring tax. Another A$5 billion will flow from the Future Fund which has been set up by the government to pay for future retirement liabilities for commonwealth employees. And a further A$15 billion will flow from M&A activity such as the proposed A$11 billion sale and de-listing of airline Qantas which is being pursued by private equity buyers.
So what impact will this excess liquidity have on the performance of super funds in the coming year? Is it possible to make returns well in excess of overall economic growth for a sustained period? No itÆs not, say the experts, many of whom are expressing concerns about the erosion of investment discipline in the market.
The frenzy is pushing up share prices and making Australian stocks expensive. Kucukalic reckons that while the S&P/ASX 200 Accumulative index rose 24% last year, only 14% of that was due to corporate earnings growth, and the rest was an expansion of price-to-earnings ratios. ôP/E expansion at this rate typically happens when demand exceeds supply.ö
The average P/E of Australian listed companies is now high, says Martin Duncan, equity strategist with JPMorgan in Sydney. ôThe average P/E multiple for industrial companies including financials has spiked in the last few months, rising to almost 17x from a long-term average of 14.75x.ö Most of the price increases have occurred in the already stretched segments such as industrials and listed property trusts, and not in the resources sector.
But thereÆs nothing wrong with high P/E multiples per se, and economists say that with China in its backyard and the global commodity markets still booming, there is some upside left in the Australian story. The question for pension fund managers is whether better value can be found in other markets, says Graeme Miller, a principal and senior investment consultant at Watson Wyatt.
ôThe flow of money has led many super funds to look more closely at global opportunities,ö says Miller, who says the demand/supply shortfall is likely to see more money going overseas. ôSuper funds have already gone from a situation where they had a strong bias to local markets, to holding up to 30% of their funds in offshore equities, so there is an evolution already taking place. Alternative assets classes have also become a lot more popular, with some funds having up to 20% in investments like hedge funds, infrastructure and commodities.ö
While they ponder asset allocations, super funds are also dealing with the practical implications of large flows of cash. The most pressing problem is how to invest the money with minimal market impact. ôThere is plenty of liquidity in the top 30 or so stocks on the Australian market, but once you get down to the bottom end of the ASX100, liquidity falls off a cliff,ö says Michael Trifunovic, manager of policy implementation at Russell in Sydney, who says this creates a significant amount of execution risk.
Trifunovic says higher cash flows have also resulted from a consolidation in the superannuation industry with funds merging together to create mega-institutions. ôSome funds have assets under management in excess of A$20 billion and can have fresh net cash flows well in excess of A$100 million a month,ö he says. ôIn the past, when super funds were much smaller, they would let their balances build up before they passed it on to their external managers, but with such large cash flows now, it has become a challenge to invest the money efficiently and in a timely manner.ö
To deal with the issue, some funds have hired internal cash flow managers. Others are employing cash-to-securities products that automate the investment process.
Looking ahead, the problem of excess liquidity isnÆt about to ebb. According to recent research by Watson Wyatt, Australia has had one of the highest growth rates in pension assets in the developed world, mainly due to the compulsory contribution scheme. The super pool has grown by nearly 15% every year for the last 10 years, even though the compulsory contribution is only 9% for most workers (the level is 15% for commonwealth employees). ôAustralian superannuation funds have nearly quadrupled over the past 10 years and now total about A$1 trillion,ö says Miller, quoting from the research. ôThese assets are now equivalent to approximately 100% of the value of AustraliaÆs annual GDP compared to just 46% back in 1996.ö
An expectation of higher wages in the coming years will see contributions increase at a greater rate. Growth will also come from new tax incentives introduced by the Howard government that encourage workers to lock away more of their savings. One of these incentives is the one-off tax break on lump sum injections, which expires on June 30. Then from July this year retirees will be encouraged to remain invested longer in their funds when the age limit on contributions and mandatory redemptions from super is increased.
ôAll these things will create an unprecedented level of demand for equities in 2007,ö says Kucukalic at Credit Suisse. ôSo I wouldnÆt be surprised if P/E multiples continue to expand making Australian stocks even more expensive relative to other markets.ö
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