Don't be scared: Australia stocks still a buy

A man uses his mobile phone in front of electronic stock boards at the Australian Securities Exchange headquarters in Sydney, Australia.
Ian Waldie | Bloomberg via Getty Images

Australia's stock market suffered a dismal second quarter, posting its biggest quarterly loss since the third quarter of 2011, but that hasn't scared off analysts.

For the first six months of 2015, the benchmark index advanced just 0.9 percent after a massive sell-off in May and June erased nearly all of the gains from earlier in the year. In the June quarter, the resource-heavy index fell 7.34 percent, wiping off $162 billion worth of market capitalization – its biggest quarterly loss in 16 quarters – according to data from Credit Suisse.

By comparison, Japan's Nikkei 225 rose 5.78 percent in the first half of the year, breaching the 20,000 mark for the first time since 2000, while South Korea's Kospi index climbed 1.91 percent over the same period. Meanwhile, China's Shanghai Composite is up around 14 percent, despite a steep and rapid correction which took the benchmark index down to bear market territory last month. Hong Kong's index rose 5.19 percent over the first two quarters of 2015.

Despite the underperformance, analysts aren't writing off Australian equities just yet.

Credit Suisse, for one, remains constructive on shares down under. But analysts at the Swiss bank lowered their near-term target for the S&P ASX 200 index to 6,000, from 6,500, according to a note earlier this week.

Apart from expectations that the Reserve Bank of Australia (RBA) will keep cutting interest rates, an unusually low cost of debt and further growth in free cash-flow (FCF) will underpin the country's share market, the report said.

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While the measure of the cost of debt has risen since the end of March from 3 percent to 3.5 percent, it is offset by a high free cash-flow yield which signifies an "unusually attractive arbitrage opportunity between debt and equities," said Credit Suisse analysts, who are expecting the S&P ASX 200 ex-Financials free-cash-flow yield to reach 5 percent by June-2016.

"An arbitrage opportunity of this magnitude should result in more buybacks and also more debt financed deals, limiting net equity issuance. In turn, the combination of little equity issuance and still strong equity demand, supported by the local pension system and the global-search-for-yield, should be a positive one for stock indices," the note said.

Meanwhile, the stock market down under offers better returns than the shrinking yields in the debt market, given that the trailing dividend yield is currently 4.4 percent and 30 basis points higher than the long-term average.

"International investors on the global search-for-yield should continue to make their pilgrimage to Australia. Each of the major components of our market— commodities, industrials [and] the big four banks—trade on a higher dividend yield than other regional markets," Credit Suisse wrote.

IG's market strategist Evan Lucas echoes that sentiment, adding that the correction in the second quarter was necessary to alleviate the index's overstretched valuations. In addition, the repricing of the market has created value, the Melbourne-based strategist wrote in a note issued early Wednesday.

"The correction and even a bear market at one of the big four banks, plus the sell-off in Telstra and Wesfarmers, meant deep value fishing could bear fruit. The pullback in the likes of Macquarie and the healthcare space also increased the amount of fish in the value pool," said IG's Lucas, who named biotech firm CSL Ltd. as the "perfect example of a value stock."

Australian shares tumbled 1.6 percent, breaking a six-session winning streak on Wednesday. The rally was the resource-heavy index's longest runup since January 21, when it chalked up 12 sessions of gains – a first since 2009.