Both the Taiwanese and Australian markets have experienced a significant downgrade in their earnings estimates year-to-date. At the same time, the two markets’ performances have also subsequently recorded year-to-date gains (as of 16 May 2012). These two factors have reduced the two markets’ upside potential for the coming three years. We have therefore downgraded our star ratings on these two equity markets. Our rating on Taiwan sees a "two notch" downgrade from 5 stars to 4 stars while Australia’s star rating has decreased one notch from 4 stars to 3.5 stars. In this article, we discuss the rationale for making these adjustments.

Taiwan (4.0 Stars "Very Attractive")

Reasons to downgrade Taiwan:

1. Actual earnings growth for 2011 disappointed, coming in significantly below our/market estimates
2. Earnings estimates for 2012 have seen a significant downgrade year-to-date
3. Taiwanese market rebounded 2.3% year-to-date (in local currency terms, as of 16 May 2012)

On these new considerations, Taiwan’s upside potential now appears less attractive and is no longer worthy of a 5 star rating; instead, its upside potential is more in line with other 4-star markets.

Although we had already expected a contraction of -10.9% in Taiwan’s corporate earnings in 2011, the actual earnings growth rate for the market came in at even lower levels. Earnings contracted -16.5% in 2011, pushing the base for comparison of 2012’s earnings growth lower.

Since the start of 2012, earnings estimates have been downgraded, with a sizable downgrade seen following the announcement of 2011 corporate earnings by Taiwanese companies. Correspondingly, 2012 earnings have been downgraded 6.6% year-to-date (as of 16 May).

These two factors have translated into a lower upside potential for the market of 52% by end-2014 (as of 16 May 2012). The upside potential is not impressive compared with the upside potential we see for other 5-star countries. As of 16 May, the China equity market is forecasted to deliver upside of 100% from current levels, while similarly-rated Hong Kong is poised for 82% upside. On our revised forecasts, the upside potential for the Taiwanese market is more comparable with other 4-star markets such as Brazil and Russia.

Table 1 indicates the earnings growth estimates of the Taiwan market according to market consensus, as of 16 May 2012. As of 16 May 2012, the PE for Taiwan equities is at 13.9X, which still represents an attractive level compared to our fair value estimate of 16X.

Reason we maintain a 4-star or "Very Attractive" rating

Despite downgrading Taiwan by two notches, we emphasise that the rating still represents a positive view on the market. Despite our star rating downgrade, we remain positive on Taiwan’s outlook because we think that the earnings downgrade cycle has ended after various global events contributed to a difficult 2011. The main factor which motivated the recent earnings downgrades was the unexpectedly poor earnings coming from 2011. Earnings were affected by weakness in the global economy, supply-chain disruptions as well as flooding in Thailand. Recent economic data indicates that Taiwan’s economy may recover at a slower-than-previously-expected pace, but we think that these new expectations have largely been reflected in the recent earnings downgrades.

The sectors which were the largest drag on earnings growth in 2011 were industrials and information technology (IT). They were the most affected by the supply chain disruptions last year as well as weakening external demand. Industrials corporate earnings dropped -63% year-on-year while IT earnings dropped -43% year-on-year.

Australia (3.5 Stars "Attractive")

Reasons to downgrade Australia:

1. Year-to-date earnings, earnings estimates for FY2011/12 have been downgraded by -5.4% (as of 10 May 2012)

2. Based on 14X fair PE, the market’s potential upside is just 42% over the next three years (as of 16 May 2012), below the potential upside of 52%-60% for other 4-star rated markets
3. Nearly no growth in the estimated earnings for S&P/ASX Index in FY 2011/12 after the recent series of earnings downgrades

The upside potential of investing in the Australia market is no longer as strong as before given that the earnings estimates of S&P/ASX Index have been downgraded successively. As of 16 May, estimated earnings in FY2011/12 and FY2012/13 (fiscal year ending June) have been downgraded by -5.1% and -3.6% respectively following the disappointing quarterly earnings results in the past quarters.

After a series of earnings downgrades, we estimate the upside potential of the Australian market at 42% over the next three years (as of 16 May 2012) based on its 14X fair PE. However, it is not as attractive as compared to other 4-star markets like Brazil and Russia whose potential upsides range between 52% and 60%. Hence, we have lowered our current star rating on Australia.

Looking into the breakdown of the forecast of S&P/ASX Index, as of 16 May, FY2012 earnings estimates for materials and retail sectors have been downgraded by -13.8% and -16.0% respectively year-to-date (as of 16 May 2012). The reasons are the expected slowdown in the demand for the materials from emerging markets and the poor consumer confidence affecting retail sales. In addition to the materials and retail sectors, other sectors like diversified holdings, consumer discretionary, and banking are expected to deliver weak performance in FY2011/12 as their year-to-date earnings for FY 2011/12 are either expected to post either slightly negative growth or marginally positive growth. Although the Australia economy is highly dependent on the energy sector where earnings estimates remain strong (expected to increase 31.6% in this fiscal year), the expected earnings growth for S&P/ASX Index in FY 2011/12 is just 0.46% as of 16 May 2012.

As of May 16, the 2012 forward PE of S&P/ASX Index is at 11.8X, which remains at a discount compared with the historical average; the star rating downgrade merely reflects the lower upside potential, but still remains at an "Attractive" level.

Reason we maintain a 3.5-star or "Attractive" rating

Earnings for FY2012/13 and FY2013/14 are expected to grow 14% and 8.9% respectively, showing analysts are confident that corporate earnings growth will pick up again. Core sectors, like material and energy sectors, are estimated to have earnings growth of 27% and 21.4% in FY2012/13. In fact, overall business sentiment remains resilient amidst slowing global economic activity, attributed to the solid demand for resources from emerging markets. In terms of valuation, 2012 forward PE of S&P/ASX Index is at 11.8X, at a discount compared with our fair PE estimate of 14X. Our downgrade on Australia’s star rating to 3.5 stars “attractive” mainly reflects the market's lower upside potential.

Investment Outlook

Our downgrades for Taiwan and Australia largely reflect earnings estimates revisions; given the attractive valuations on both markets, we reiterate our positive view on these two markets. On the whole, recent market weakness has brought down equity valuations across the board, marking an attractive entry point for equity investors with a long-term investment horizon. Reflecting our positive view on equities, the majority of equity markets under our coverage continue to sport "attractive" or "very attractive" ratings despite the ongoing market volatility. We maintain our overweight stance on equities vis-a-vis bonds.