Reece Birtles of $10 billion Australian equities manager Legg Mason Martin Currie says we're about to enter a "great environment" for consumer stocks as deflationary forces abate and corporate profit margins expand.
Stocks like AGL Energy, Woolworths, Coca-Cola Amatil and Insurance Australia Group stand to benefit from expanding profit margins as prices rise while costs are held steady, Mr Birtles said at a media briefing in Sydney on Monday.
Mr Birtles said the past five years, which have been characterised by low inflation and falling bond rates, came about because of the sharp falls in commodity prices.
But that started to change last year, as commodities began to rise and nominal GDP growth picked up. That should continue, which means bond yields will continue to rise, but more importantly, so too will corporate revenues.
"This is just a much better world than we have had in the last five years," he said.
For companies that have been forced to focus on cost cutting to maintain their profits, a pick-up in revenue growth will translate into higher profits.
"Market valuations are not that exciting from a price-to-earnings point of view – but profit margins in Australia are low and the returns on equity for the average Australian company is low."
We are heading into a situation where earnings per share growth will accelerate into the double digits – as opposed to earnings contraction.
"That's a great environment for equities and puts a lot of pressure on bond yields. How you can have 1.5 per cent bond yields when nominal GDP is growing at five to 6 per cent, just won't happen".
Profit resilience
"The resilience of profit margins in such a weak revenue growth environment has been amazing and people will be surprised at the ability to expand margins when revenue growth improves."
Mr Birtles said the fund is keen on consumer staples stocks such as Woolworths and Coca-Cola Amatil, a view the fund didn't hold at the start of last year.
"[Woolworths and Coca-Cola Amatil] have been under pressure but they're strong businesses with strong market shares and have been reworking themselves to deal with those challenges. Consumer staples have lost their defensive status but that will return and they are going to look very cheap," he said.
AGL Energy was an "extremely well positioned business," he said.
"Electricity prices are going to rise as coal-fire power stations get shut down. AGL have announced the closure of the Hazelwood [power station] and it changes the supply/demand imbalance of the market in Victoria. Higher electricity prices will flow through in response to those closures."
The fund also favoured several non-bank financial institutions and singled out IAG because of its strong market position in car and home insurance. An improvement in insurance pricing and an increase in interest rates should benefit the insurer, Mr Birtles said.
The rise in bond rates has triggered a sell-off in stocks that were regarded as "bond-proxies" – because income-focused investors turned to them as a substitute for low yielding bonds.
Even though Mr Birtles sees bond yields rising, some stocks like Transurban that have fallen out of favour present a good buying opportunity because its revenues are tied to inflation and it can potentially grow its distributions.
