Upside Down Under

With deeply uncertain economic realities at home, investors are searching for an alternative market, preferably in an industrialized country with low correlation to the U.S. markets. Australia might just do the trick. For most American investors, Australia conjures up images of the outback or scenes from the movie Crocodile Dundee. But, as The Economist put it in a recent article, “Australia is like another planet. As the economies of America, Europe and Japan appear to be stumbling for the second time in less than three years, Australia continues to boom. The country is now in its 12^th year of uninterrupted economic expansion, having shrugged off both the East Asian crisis of 1997-1998 and the global turndown in 2001.”

According to the Economist Intelligence Unit, five-year annualized GDP growth through 2002 has been a remarkable 3.81 percent, versus less than 3 percent for the U.S. And EIU projects Australian expansion of 3 percent in 2003. In fact, Australia outshines the U.S. in many major macroeconomic metrics, including gross fixed investment, industrial production, savings rate, budget balances and debt as a percent of GDP.

Not surprisingly, this has helped contribute to superior equity performance. Through March 2003, the global index tracker FTSE reported Australian stocks were off just 3.16 percent over the past 12 months — in dollar terms. Over the past three years, annualized returns are up nearly 2 percent. And over the last five years, they gained 2.45 percent, easily beating U.S. returns for the same period.

Australia is perhaps the healthiest developed economy around. According to a recent OECD survey, “dogged pursuit of structural reforms across a very broad front and prudent macroeconomic policies have combined to make the Australian economy one of the best performers in the OECD, and also one notably resilient to shocks, both internal and external.” The IMF adds, “despite the synchronized slowdown in the rest of the world, conditions for sustained high growth in Australia are in place.”

In addition, the Australian dollar, which had been on a decade-long decline, has begun to rebound. With more than a third of the economy geared to commodities, the currency depreciated on the back of declining metals and agricultural prices and a sharp reduction in interest rates.

Since hitting a low of $0.477 to the U.S. dollar in April 2001, the Aussie dollar has sprung back by nearly 30 percent to $ 0.60, on the back of recovering commodity prices, rising interest rates and the falling U.S. currency. Thirty-day bank notes are currently yielding 4.70 percent.

Annick Trottier, a principle at the economic consultancy Global Insight, believes the Australian dollar is likely to maintain its present strength through the rest of the year, appreciating to $ 0.63 by the end of 2004 due to improving capital inflows and recovering commodity prices.”

Banking on Banks

But what to buy? There is no convenient “Australia Fund,” so the next best proxy may be Australian banks. Banks were among the country's leading performers, registering one-, three-, five-year annualized returns — in dollar terms — of 2.75, 14.58, and 9.77 percent, respectively.

There are several factors that continue to make large Australian bank stocks attractive for U.S. investors. First, many are available in the U.S. as ADRs. They also offer significant dividends. Consider that Australian banks — four of which rank among the world's 50 largest companies — paid dividends of over 5 percent in 2002, according to JP Morgan. A recent rally in these shares has pulled many yields below five percent. Still, several, like the $18 billion Commonwealth Bank of Australia, are paying out more than 6 percent.

In a recent note entitled, “Why Australian Banks Will Outperform,” JP Morgan analyst Brian Johnson argues, “Australian banks are defensive, combining strong growth momentum with undemanding valuations.” Despite having spiked by more than 10 percent in March, Johnson favors Westpac Banking, which he estimates will average earnings-per-share growth of 9 percent over the next two years. Johnson also reckons that the dividend, which now yields 4.5 percent, is not only safe but will actually increase.

Though he is concerned by the recent rise in bond rates, Salomon Smith Barney's Mike Macrow is also “overweight” on the Australian banking sector. He is especially keen on Australian and New Zealand Bank, “based on dividend yield support, attractive valuation and relative earnings certainty supported by ANZ grabbing an increasing share of the domestic loan market.”

Goldman Sachs recently highlighted National Australia Bank as a favored stock, citing its “continued strong mortgage growth, improving business lending and sound asset quality.”

Derek Izuel, lead manager of AIM's Global Trends Fund, offers buy-side support for Aussie banks. “The country is a safer and more reliable economy than most other developed markets,” Izuel explains, “and we consider its big financials lower risk and less volatile than other U.S., Asian and European financials.”

While his fund's mandate limits exposure to Australia, Izuel thinks investors could be well served by investing up to five percent of their assets into quality Australian bank stocks. “When you look at the current yields, the underlying strength of the Australian economy, sound fiscal policy, and the potential currency appreciation, Australian bank stocks offer attractive ballast to virtually any portfolio.”

Risks

While Australia has sidestepped troubles that have been depressing the world's other major markets, some analysts fear that protracted global slowdown could eventually wash up along the country's shores. This could soften commodity prices and weaken export demand.

Terrorism also remains a hard-to-quantify risk. After last fall's attack in Bali where scores of Australians were killed, the country's bank stocks slumped by 20 percent. And Australia's participation in the Iraq war could make it a target of future attacks. Of course, that buy-the-dip turned into a buying opportunity as investors apparently recognized the dividend and growth opportunities offered by these shares.

BCA Research analyst Marco Lettieri posits an alternative strategy if some investors are unnerved by buying into a rising market. “If you think the rally in banking shares is getting long in the tooth,” explains Lettieri, “short-term government paper offers comparable yields and currency exposure with virtually no risk to capital.”

Small appreciation of the Australian dollar could turn such an investment into a double-digit gain for US investors. But if one buys into the country's economic story, then gaining equity exposure through relatively stable and defensive bank shares is a more compelling and complete means of playing the miracle down under.

Upside Down Under

Australian banks, all available as ADRs, offer what embattled investors crave: Strong yields, upside potential and non-U.S. exposure.