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An occupational hazard of writing weekly sharemarket columns is having to produce buy or sell ideas. Telling readers to “watch and wait” does not make for catchy headlines that sell magazines or drive internet traffic. But patience is a key investment skill.

Value investors will need to hold their nerve in the lead-up to the September Federal election. A 5 per cent fall in the S&P/ASX 200 index in May was concerning, and a portent of things to come if the Australian dollar’s decline is disorderly and the resource boom ends abruptly.

The good news is that sharper market falls – possibly a 10 per cent correction over the next few months- will provide a buying opportunity in some of the market’s best mid-cap industrial stocks. The exceptional companies are not hard to identify; the challenge is buying them closer to, or preferably below, fair value.

Stocks such as Flight Centre, REA Group, Carsales.com, TPG Telecom, iiNet, Domino’s Pizza Enterprises and McMillan Shakespeare look ripe for a correction. They are terrific companies, but after soaring at least 50 per cent over 12 months are prime candidates for profit-taking.

Interestingly, these stocks were heavily sold off during the May market pullback. Flight Centre, for example, has fallen from a 52-week high of $41.88 to $39.75. REA Group is down from a 52-week high of $33.66 to $27.88.  Domino’s has dropped from almost $14 to $11.85.

Heavier share-price falls would not surprise in such a nervous market. If the ASX 200 can convincingly hold support around current levels, these stocks could recover ground quickly. If the index breaks below support, watch for stocks that are “priced for perfection” to be among the first sold.

It is hard to see a catalyst to drive the market higher in the next few months.  The resource boom is slowing faster than expected and other sectors show few signs of picking up the slack. Business and consumer confidence will weaken and the lead-up to a Federal election is rarely good for business.

At the same time, the Australian sharemarket is in the seasonally weak period around May, and looks fully valued after a sharp gains in the past 12 months. Globally, the US and Japanese sharemarkets are ripe for heavier falls after stunning gains in the past year.

The “stabilisers” will eventually come: the Australian dollar is heading towards US90c and the official cash rate will be at or just above 2 per cent by year’s end. The likelihood of a new Federal government – and less policy uncertainty – would also boost business.

But these stabilisers take time to kick in. The likely scenario is 2013-14 being another year of sluggish growth, economic uncertainty, and high sharemarket volatility. Stocks priced on nosebleeding valuations will find the going tough if their PE multiples contract by 20-30 per cent.

Yet if one looks to 2014-15, the prospect of a 2 per cent official cash rate and an Australian dollar below US90 cents will be a big stimulus, although not enough to get the economy growing much above its trend rate given the big hole that will come as mining investment contracts.

As companies become more optimistic, average hours worked and income will slowly rise. Modest property price rises will make homeowners feel more confident and companies could finally see some top-line revenue growth. Non-mining sectors could take the baton of economic growth from mining.

Yes, there are plenty of “ifs”, “buts” and “coulds” in that scenario. And much that can go wrong, especially if Australia talks itself into recession. A slew of increasingly bearish media articles and economists’ warnings of possible recession, while valid, will take a toll on confidence. Further, the global economy looks as problematic as ever.

If I’m right, 2014-15 is when the effects of the stabilisers – sharply lower interest rates and an easing Australian dollar – will kick in. Don’t expect any sharp turnaround or boom, but enough to ward off the risk of recession and get the market pricing in some growth again.

Modest top-line growth plus productivity gains that Australian companies have engineered through cost cutting should support high earnings growth, and ultimately higher valuations. Perhaps the half-year reporting season in February 2014 will be a turning point as the market prices in higher growth during 2014-15.

But the next six to 12 months look rough as this economy goes through a painful adjustment from a slowing resource sector. After an unprecedented mining boom, it is not hard to envisage the adjustment will be harder than many expect, and that parts of the sharemarket need to fall.

Prime candidates for sell-offs include Australian Real Estate Investment Trusts (A-REITs), telecommunication and internet stocks, star mid-cap industrials that have soared more than 50 per cent, and retailers, which need to give back some of their big gains this year.

The point is: a number of exceptional companies, such as those identified earlier – could get cheaper in the next six months. I doubt they will get to bargain prices, but buying these stocks at 30 per cent below peak prices is much a better strategy than chasing them higher.

It all comes down to being patient, watching and waiting, and having a strong list of stocks to buy when the market falls to reflect a more painful economic adjustment ahead.

 

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Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Feb 14, 2013. The author implies no stock recommendations from the above commentary. Readers should do further research or talk to their financial adviser before acting on themes in this article.