The stock market isn’t properly working in Australia, says a Credit Suisse report, and investors can benefit from a relative value spread. As Aussie corporations look to debt markets to generate capital more so than the Australia’s stock market, a correlation divergence is apparent that, with a particular buyback season in Australia’s Stock Market approaching, might provide investors a mean reversion opportunity.

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Australia's Stock Market

The IPO function of Australia's Stock Market is not working

The intended purpose of the stock market was not to allow what critics call gambling, but rather to provide business a method to obtain capital. When businesses have both working and growth capital it employees people and in the process has potential to generate a positive return for investors.

Looking at this core “economic and social function” to provide equity capital to companies, Credit Suisse analysts Hassan Tevfik and Peter Liu say the system is “broken.”

Over the last 10 years, Australian companies have generated $40 billion yearly in equity capital from Australia's stock market, which “has helped create jobs, supported our economy's solid momentum, and facilitated the development of new products.”

But that changed in 2017, rather dramatically. Only a “dismal” $1 billion generated to date, the weakest by far in nearly a decade. This leads Tevfik and Liu to the conclusion that “the stock market is not working.”

Debt not stock is getting the nod in Australia

It is the credit market, not stock market, that is the largest source of financing for companies in Australia. Corporations prefer to spin off debt which can be converted to equity rather than go directly to Australia's stock market to gain their financing.

The credit market is the most cost effective method for a corporation to receive financing, Tevifik and Liu claim, pointing to a large number of debt to equity swaps that have occurred thus far as signs of life.

Even companies that were originally scheduled to engage in IPOs have shifted course and gone the private equity, acquisition or debt-driven route. The large utility concern Alinta is an example. The company set expectations it was planning on a $4 billion IPO but changed course, selling to Chow Tai Fook instead after they provided a combination of debt and cash to finance the transaction.

The stalling of equity issuance has resulted in “bankers (that) are not happy,” as the fees they generate from an initial public offering are often significant. 2009 was a banner year, with $122 billion in IPOs keeping equity desks busy, but 2017’s muted IPO trend is preventing these desks from ringing the IPO revenue generation bell.

If there is one benefit, however, it comes in the form of an arbitrage trading opportunity.

Australia's Stock Market

Sovereign to corporate bond divergence and its triangulation with the stock market creates a relative value investment

With the flow to the debt markets strong, a market imbalance has been created. The average debt cost is near 3%, the Credit Suisse researchers observe, which is 200 basis points less than the ASY 200 Free Cash Flow Yield.

In part, the oddity can be seen in the increasingly wide spread between government and corporate bonds. The report points to government bond yields rising over the previous 12 months, but corporate bond yields, a typically correlated asset, having “hardly budged as credit spreads have tightened in a risk-on world.”

The divergence from a price correlation mean will likely lead to convergence.

“The potential for capital arbitrage has hardly ever been as great as it is now,” Tevifik and Liu write. “Perhaps this unusually large arbitrage opportunity between debt and equity is the reason why private equity continues to linger around our market,” particularly as such firms look to retire equity in favor of debt.

Invest in Australia's stock market and look for earnings per share accretion that results from buybacks, a prospect that is categorized as “unusually high.” Such activity “bodes well for future equity market returns,” particularly as the current reporting period approaches, one where buybacks are often more pronounced.

Specific Australian stocks where buybacks could result in a meaningful price appreciation opportunity include Qantas, BHP, Computershare and Lend Lease.