Potential Surprises, And Value Traps, This Results Season

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This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

The FNArena Sentiment Indicator sank officially to a new low this week, indicating overall market sentiment as expressed by individual stock recommendations by the major experts in the Australian share market has never been as bullish as it is right now. For the first time in five years more than half of all stock recommendations in the market are a Buy (or an equivalent of Buy). In line with this the total amount of Sell ratings has fallen to an all-time low of a little over 8%.

Overall market sentiment post the January correction was perfectly captured by strategists at Macquarie in their market update this week. Until last month Macquarie had a negative view on the Australian share market’s prospects for 2008. Now that we’ve had the correction, however, the overall mood at Macquarie has improved considerably. Taking share prices and indices as at January 31 as a starting point, the strategists now forecast a total return of 11.3% (including 4.2% in dividends) for the S&P/ASX200 index and a return of 9.9% for the ASX Small Ordinaries (including 4.9% in dividends) by year end.

However, and especially in the light of January’s absolute carnage across global share markets, a projected 7.1% return in average share price appreciation doesn’t seem that much. It certainly fails to trigger any unbridled excitement when compared with the returns investors have become used to over the past four years.

Does it warrant a Buy recommendation for every two ratings issued? Of course not. As I have pointed out in previous writings (see for instance “Rudi On Thursday”, January 23, 2008) securities analysts are still catching up with the new reality of slowing global economic growth, rising inflation, falling investor risk appetite and rising costs for doing business in general. Average earnings estimates have come down from 12% to 9% since December, and are still declining further, and valuations and price targets are falling like rocks from a cliff.

If you think that last statement is a bit of an exaggeration, consider the following examples. On Tuesday analysts at Citi cut their price target for AXA Asia-Pacific ((AXA)) from $7.90 to $5.60, that’s a reduction of nearly 30%. That same day colleagues at Credit Suisse reduced their price target for Bradken ((BKN)) from $12 to $9.57, a loss of more than 21%. On Monday Merrill Lynch pulled back its target for Toll Holdings ((TOL)) from $15.50 to $12.50, a minus of nearly 20%.

No doubt, you will all have noticed that I didn’t have to pick any Allco Finance ((AFG)), HFA Holdings ((HFA)), Boom Logistics ((BOL)) or Centro Properties ((CNP)) to illustrate my point, while at the smaller end of the share market average price targets (not just cuts by one single broker) are coming down by 50%, 70%, 100% and more.

Regardless of all of the above, the amount of Buy recommendations in the market has only increased further since the beginning of 2008. Over the past week, for instance, the total of 25 recommendation downgrades has been outnumbered by 36 recommendation upgrades. How to explain this?

Queensland based bankinsurer Suncorp-Metway ((SUN)) delivers us the perfect illustration of why the number of Buy recommendations is currently as high as it is. Six out of ten equity researchers in the FNArena database currently rate the stock as a Buy. Yet few among these six will discount the possibility that the shares may weaken further in the months ahead, before finally (and hopefully) starting a recovery.

From a valuation point of view, few experts will doubt the shares are currently lightly valued, trading on an estimated price earnings ratio (PER) of a little over 13 for FY08 and around 10 for FY09. At Tuesday’s closing share price the difference with the average price target is in excess of 22%, a gross dividend yield of more than 7% not included (7.5% if you want to take FY09 forecasts as a reference).

It is because of stocks such as Suncorp-Metway that value investors and long term oriented fund managers are currently having a field day in the Australian share market. The problem is, however, nature hasn’t exactly been kind to Queensland lately and Suncorp-Metway was already facing some serious headwinds. The market is sceptical about the integration of Promina, management has had to acknowledge margins are under pressure and more storm claims than usual have taken the wind out of the company’s earnings prospects. Management has tried to reverse the trend by promising it will deliver more synergies from the Promina integration, but most securities analysts are thinking there’s only so much one can squeeze out of a lemon without breaking its skin.

In other words, overall market enthusiasm is rather low at the moment, despite the apparent value on offer, a dividend yield in excess of 7% and the ongoing uncertainty in the markets. Don’t forget also that Suncorp-Metway combines two of the least popular types of operations in the market: banking and insurance. Only a builder or listed property trust would rank lower at this stage. Oh, and investment bankers and specialised mortgage lenders, of course.

Here’s another way of looking at it: at the end of December Suncorp-Metway shares cost nearly $17 a piece. Throughout the January turmoil they sank as low (intraday) as $14.00. The lowest close was on January 22 when they ended the day at $14.20. On Tuesday they closed at $15.67, 10.3% above their lowest closing share price in January and still nearly 8% below their level at the end of December. This means the projected dividend payout nearly fully covers the risk that Suncorp-Metway shares will again fall as deeply as they did in the midst of last month’s panic and margin call driven sell-down.

That’s how cheap Suncorp-Metway shares are currently valued.

All this does by no means indicate investors will start jumping on Queensland’s pre-eminent value proposition tomorrow. Not everyone has the stomach to sit on their shares only to see them languishing, range trading or losing value in the short to mid-term. What’s more, not everybody is in the market with a longer term view. And that’s why Suncorp-Metway shares are unlikely to go up much further in the short term. If anything, you can probably buy them a tad cheaper in a while from now. That doesn’t take away the fact that the stock is currently widely regarded as “undervalued” at current price levels, and this explains why six out of ten experts rate it a Buy.

These ratings are not so much an indication that Suncorp-Metway is poised to outperform the broader market, or even its peers, in the year ahead, it’s more of a “this stock is arguably undervalued and while we have no idea when and from where the catalyst will come, a time will arrive, at some point, that a more normal valuation will be restored. On that day we’d advise you to be a shareholder in this company.”

As things stand right now, the company should again display some positive earnings momentum in FY09 and as said before, the shares are currently on offer for ten times estimated FY09 profits only.

Suncorp-Metway is far from the only one in this position. Some would argue fellow insurer Insurance Australia Group ((IAG)) has a similar story on offer. As it happens, IAG’s market multiples, prospective dividend yields and gap between share price and average target are all eeringly close to Suncorp’s. Others will point you in the direction of Aristocrat Technologies ((ALL)), or Lend Lease ((LLC)), or most of the banks. The problem is, however, the market is currently driven by sentiment rather than by value and this means that at least half of all Buy recommendations represent a so-called “value trap” for investors with a shorter term horizon.

This, obviously, makes short term stockpicking more of a delicate operation (and equally for investors with a longer term view but who don’t like to have a portfolio that doesn’t seem to be making any progress). Luckily, we are about to enter the February results season. Past analyses have found that 75% of those companies that manage to surprise the market on the upside with their reported earnings tend to outperform the broader market for up to three months after the event. Likewise, and as shown by recent examples such as Zinifex ((ZFX)) and Emeco ((EHL)), those who fail miserably are likely to be punished accordingly.

Given the negative trend in forecasts and targets, the provided management outlook for the year ahead will be as important as the actual results. This means that both shorter term and longer term investors might be looking at the same investment targets in the coming weeks.

The key question is thus: who’s likely to surprise and who’s likely to disappoint this month?

Let’s start with some perennial underperformers. Wealth managers such as Perpetual ((PPT)) and Platinum ((PTM)) have gone through some rough patches in the past year. Though both have highly regarded track records, their performances have lagged market expectations and quite consistently so. Will they surprise on the upside this time around? One can only assume the odds are pointing into the opposite direction.

Similarly, in the light of recent share market volatility and the uncertain outlook, companies such as AMP ((AMP)), Henderson Group ((HGI)) and AXA Asia Pacific are equally more likely to disappoint, if not to provide investors with very careful outlook statements. The same applies to IOOF Holdings ((IFL)).

However, the company in the financial sector that is more often mentioned than any other as a potential candidate to disappoint with its upcoming results release is Commonwealth Bank of Australia ((CBA)). Some analysts have gone as far as to suggest that if CBA fails to meet market expectations, the whole sector is likely to feel the impact from this. Margin pressure, wholesale funding costs and mortgage stress have become the targeted terms for the sector, and for CBA in particular.

Given that Challenger Financial ((CGF)) might disappoint as well, financial stocks might be in for some tough love in the weeks ahead.

The above mentioned Suncorp-Metway is expected to release a weak, if not a weaker than expected result this season. Expectations are similar for IAG.

One of the companies that has built up a legacy of disappointing the market with its interim results is Foster’s ((FGL)) and some securities analysts believe chances are high this year the pattern will be repeated. As market expectations have risen for Coca-Cola Amatil ((CCL)) over the past few months, MD Terry Davis and his team are facing a completely different challenge: can they still surprise or even meet these high expectations? Similarly, McGuigan Wines ((MGW)), soon to be named Australian Vintage Ltd, has developed a habit of continuous disappointments. It’s rather unlikely this year will be different given the ongoing tough industry conditions.

Having the ability to surprise the market with your interim or final results is not just about good management and a positive industry background. Companies such as the Australian Stock Exchange ((ASX)) and WorleyParsons ((WOR)) for instance, are poised to release some finger-licking result reports. However, the market has already anticipated this in advance, making the odds of a temporary disappointment at this stage bigger than for a genuine earnings surprise.

Perennial disappointer Spotless ((SPT)) is believed to remain true to its legacy again, and the same may also apply to metals producers with a shaky history. Lihir Gold ((LGL)) already proved true to its old habits by reducing market expectations prior to its results release, and so did Zinifex, as well as Alumina Ltd ((AWC)), but what about Minara Resources ((MRE)) , or Independence Group ((IFO)), or Jubilee Mines ((JBM))? Resources companies likely to do better than expectations are believed to include Copperco ((CUO)), Felix Resources ((FLX)) and Oxiana ((OXR)). Expectations for the likes of Perilya ((PEM)) have already been significantly lowered, any further disappointment would surely be seen as an exceptional achievement by company management.

Austar United ((AUN)) has a positive history and some analysts believe the odds are again in favour of a positive surprise. The same goes for JB Hi-Fi ((JBH)) and Qantas ((QAN)). Both are expected to come out strong this season. JB Hi-Fi may meet some market scepticism because of the outlook for consumer spending in Australia. This is the reason why some experts rank Harvey Norman ((HVN)) and David Jones ((DJS)) with the potential disappointments. JB Hi-Fi shares have met some heavy selling pressure recently, but the company is on many lists for a potential earnings surprise. The Reject Shop ((TRS)) is believed to be in a similar position as JB Hi-Fi, while Fantastic Furniture ((FAN)) should come out strong as well.

There are suggestions that IT market darling Oakton ((OAK)) may not meet expectations this year as the acquisition of Acumen may have pushed the seasonal balance towards the second half of its fiscal year. Others, however, think this is nonsense and simply expect a continuation of the company’s positive track record.

Expectations are not high for perennial underachiever Wattyl ((WYL)) and risks for James Hardie ((JHX)) are believed to be to the downside as well, while Wesfarmers’ ((WES)) fortunes are believed to be directly linked to the improving coal price outlook (analysts think the other operations, including Coles, are poised to disappoint).

Talent Two International ((TWO)) has a history of producing very good results and this time is expected to be no different. QBE Insurance ((QBE)) has a similar history of outstanding results. Continuation of the past trend is expected. Computershare ((CPU)) is often mentioned as a potential surprise candidate (as is Qantas, by the way). Babcock & Brown ((BNB)) is featuring on multiple lists, with some also mentioning BlueScope Steel ((BSL)).

Foodproducer Goodman Fielder ((GFF)) may well surprise, some experts speculate, but only because market expectations have become so negative that it would almost deserve a medal if management would release a result below expectations. Similarly, Adelaide Brighton ((ADB)) may not only surprise the sceptics, management might even announce a surprise special dividend.

Merrill Lynch’s team of Small Cap specialists has five favourites for the upcoming results season: Automotive Holdings ((AHE)), Imdex ((IMD)), Mineral Resources ((MIN)), SMS Management & Technology ((SMX)) and Navitas ((NVT)). Navitas is the former IBT Education.

Some analysts believe Sol Trujillo’s Telstra ((TLS)) is equally poised to surprise. Note that ABN Amro’s telco specialists anticipate strong results from several companies in the sector, including Amcom ((AMM)), Hutchison ((HTA)), Reverse Corp ((REF)) and Pipe Networks ((PWK)).

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