29 June 2010, Financial Advisor

The closest thing to an investment panacea for dealing with today’s market uncertainties may be Down Under. In virtually every respect, Australia offers investors the best of all worlds.

Start with a search for cash alternatives to our microscopic money market yields. In mid-June, one-year AAA-rated Australian Government Treasuries were yielding 4.45 percent or 416 basis points more than equivalently termed US Treasuries.

This huge spread is not because Australia is suffering its own Greek drama. On the contrary, Australia is perhaps the healthiest developed market economy. The country is resource rich, has among the highest-ranked business environments anywhere, unemployment is relatively low, consumers are spending, and so is China—Australia’s top importer.

The country has enjoyed more than 17 uninterrupted years of economic growth where expansion has been averaging more than three percent a year. And the economy sidestepped the banking and housing crisis that mired the rest of the world’s major markets in 2008 and 2009. According to the Economist Intelligence Unit, the country’s housing prices have held close to their historic peaks hit in 2007. And with virtually no subprime exposure and loan arrears remaining manageable, Australia’s banks have not only remained profitable throughout the global banking crisis, but unlike US banks, they continue to lend that’s supporting growth.

Rising Rates

So impressive has been the country’s economic resilience that the Reserve Bank of Australia was the first major central bank to start bumping up overnight rates. Starting last fall, it has now done so six times—25 basis points at a clip—which has sent official rates up to 4.50 percent. This is a testament to the central bank’s long-term commitment to keeping a lid on inflation. For decades, interest rates have been generally higher there than the rest of the developed world. So investors shouldn’t blink at these sweet yields.

Chuck Butler, President of St. Louis-based Everbank World Markets, thinks the Australian overnight rates are heading up to five percent by year’s end. This suggests that investors looking to park money in Sydney would likely be best served by staying with short-term maturities to keep from getting hit from price declines that would accompany rising rates.

Everbank uniquely offers retail investors access to sovereigns and foreign CDs at a $20,000 minimum. Foreign exchange conversion fees, necessary to buy and sell Australian dollar-denominated securities, is 75 basis points above Interbank Rates—those quoted in the newspapers and typically available only to prime customers.

Everbank charges 50 basis point commissions on sovereign purchases. That takes a sizable chunk out of a short-term income play. But there are no commissions when bonds mature back into cash.

This means that after all expenses, investors can still expect to pocket about a four percent yield on one-year Australian sovereigns. An additional 20 to 30 basis points can be had by venturing into highly-rated state bonds—such as New South Wales and Queensland, which trade with adequate liquidity. And investors can secure an additional 150 basis points when buying into some of the country’s “AA” bank bonds, such as those of Australia & New Zealand and Westpac.

Most important, if exchange rates aren’t favorable when a bond matures, investors can simply continue to rollover proceeds into another bond issue and hold until currency conversion is positive. Over the long term, most FX analysts believe this is very likely.

Stocks

Another compelling source of yield are stocks. The Financial Times reports that Australian equities are the highest dividend-paying developed market with a current average yield of four percent. The only developed economies paying more are those in the eye of the European sovereign debt crisis: Portugal, Spain, Italy, and Greece.

But Australian stocks are more than just income plays. The global market data tracker, MSCI, reports Australia among the top performing developed markets in US dollar terms. One-year total equity returns through the end of May 2010 surged 26.7 percent—topping the US market by 5.7 percentage points and the international developed-market benchmark, EAFE, by nearly 20 percentage points.

Australian stocks lost 5.64 percent annually over the past three years, which include a period in which investors dumped equities and sold off foreign currencies. But that was still 289 and 700 basis points a year better than US and EAFE performed, respectively. Only Canada performed better, off 1.76 percent a year.

Over the past five years, again only Canada outpaced Australia, 11.4 percent versus 8.97 percent. Still Sydney shares outperformed the US by 850 basis points per year and EAFE by 710 bps per year, respectively.

And ten years out, no developed market has done better than Australia, which soared 12.56 percent annually, outpacing Canada by 430 basis points a year, the US by 1350 bps per year, and EAFE by 1149 bps per year.

Australian shares have soared not only because of the country’s sound economics, but because a number of companies that trade in Sydney are global industry leaders.

OTC-traded Macquarie Group is among the most innovative investment banks in the world, [MQBKY: OTC] excelling in infrastructure financing. Shares are up by one-third over the past year. The bank’s business model is based on buying various hard assets, ranging from airports and highways to real estate and assembling them into funds. For its recently closed fiscal year 2010, Macquarie sold off some of these funds, which contributed to an increase in net profit [in line with it’s five-year earnings growth rate] of 20 percent to more than A$1 billion. Selling at a trailing PE of less than 14 coupled with a dividend of 4.4 percent makes the bank a compelling play.

Not to be confused with the former US retailer, Australia’s Woolworths Ltd. [WOW: ASX] enjoys a decade-long annual earnings growth rate of 18.6 percent. This has supported steady stock and dividend expansion. Morningstar analyst Peter Warnes describes Woolworths as “a defensive growth stock with a solid balance sheet and imposing [competitive] moat” that separates it from the rest of the sector. A low volatile share price has kept the stock remarkably steady, even during the worst of the recent crisis, and a 3.9 percent yield has enabled the trailing total return over the past year to exceed 11.5 percent [in local currency terms.]

As generators of substantial cash flow, incumbent telecom service providers have become today’s top yield plays. Few are spinning off as much cash as Telstra [TLSYY: OTC], whose current dividend is close to nine percent. However, that currently represents the vast majority of its earnings.

Telstra is certainly prone to competition, but remains the country’s leading telecommunications and information service provider. And it recently signed a non-binding agreement where it will share its infrastructure with the National Broadband Network. This clears up nagging regulatory issues and is expected to generate A$9 billion [measured in present value terms] for Telstra from competitors using its network.

Its shares have been volatile of late. Earnings growth rate has been trending in the low single digits. Still, the stock managed to gain more than 12 percent over the past year.

A significant part of the Australian economy is driven by commodities, and the biggest industry player anywhere is Melbourne-based BHP Billiton [BHP:NYSE]. According to Morningstar analyst Mark Taylor, a key to the company’s success is its low-cost operations, strong balance sheet, and geographic exposure to relatively safe havens. “This is a foundation resource investment for conservative portfolios,” says Taylor. And with threat of a super profits tax on domestic miners diminishing with the recent change in government leadership, pressures on BHP’s shares may come off.

If one believes in the current global recovery thesis, BHP should benefit. But commodities, volatile by nature, are a leveraged play on growth, and BHP is exposed to risk that forward expansion could be uneven.

Banks may still be a four-letter word to most investors. But not in Australia. They got smacked about during the market meltdown. But that was largely a matter of guilt by association.

According to a recent International Monetary Fund report, “the direct impact of the financial crisis on the quality of assets on [Australian] bank books has been limited so far, especially for large banks.” The reasons: much less leverage than western banks, small exposure to U.S. subprime mortgage loans and derivatives, conservative capital adequacy rules, and regular stress testing.

Westpac Banking [WBK:NYSE] is an easy way into domestic retail, corporate and institutional banking. Shares have completely recovered from the crisis, but have been volatile of late as investors have again shied away from banks and have sold out of foreign currencies, further reducing the price of the bank’s US-traded shares.

Morgan Stanley bank analysts Richard Wiles is concerned by weak margin trends and challenges in the commercial property market. But overall, he sees higher earnings driven by lower loan loss charges and cost controls, solid capital and provisioning levels, and the most attractive risk-adjusted value of any Australian bank.

Fund Approach

A limited number of US-traded funds offer pure Australian exposure. For market-cap weighted exposure, there isn’t anything more spot on than iShares MSCI Australia Index [EWA: NYSE]. This passively managed ETF offers a dividend yield of 3.28 percent, trailing one-year returns of more than 34 percent, and nearly 30 percent exposure to the five stocks mentioned above.

American Stock Exchange-traded Aberdeen Australia Equity [IAF] is an actively managed closed-end fund that’s currently trading at a slight discount to its underlying value. Longer term, it has outperformed the broad index. But over the past year, it delivered a gain of just 3.89 percent, largely due to a double-digit premium having turned negative—a unique risk in closed-end fund investing. Presently more than one-quarter of the portfolio is invested in three of the above-featured stocks.

A number of Australian-based investment trusts, equivalent to our mutual funds, can be purchased by US investors. The small- to mid-cap-focused Wilson HTM Priority Growth Fund, with $95 million in assets, is the best performing diversified fund around. Since its inception in July 2005, it has soared at a compound annualized rate of more than 27 percent [local currency terms] through May 2010. You need A$40,000 to get in, and the fund charges a performance fee on top of its annual expenses. But it seems worth it.

Rydex’s Australian Dollar Trust CurrencyShares [FXA: NYSE] offers a pure ETF play on the local currency, which over the long term, has been the source of much of the country’s outperformance. Over the past year through mid-June, it has gained nearly 14 percent. Despite its strong fundamentals, the Aussie dollar has not been a one-way ride, having lost 40 percent its value during second half of 2008, only to have made most of it back by the end of 2009.

The current US dollar rally is giving many currency analysts pause about the near-term prospects of the Aussie Dollar. Scott Hixon, portfolio manager of Invesco’s $7 billion Global Asset Allocation Team, is bearish over the coming year because he expects investors to remain nervous about the global recovery and will continue to seek safety in the US dollar. “Currently,” says Hixon, “the US dollar’s status as the world’s currency reserve trumps most fundamentals.”

Over the next year, he thinks this could drive the Aussie dollar down by 10 percent or more against the dollar. But further out, he believes Australia’s superior fiscal and trade balances, higher interest rates, and correlation with rising commodity prices will eventually drive up the Australian dollar and all investments denominated in the currency.