Is There A Third Option Between Expensive And Cheap?

This story features PERPETUAL LIMITED, and other companies. For more info SHARE ANALYSIS: PPT

(This story was first published on Monday and sent via email to paying subscribers)

By Rudi Filapek-Vandyck, editor FNArena

Amidst a general view that earnings forecasts by securities analysts are too high, both in Australia and elsewhere, and therefore likely to trigger ongoing downgrades in expectations, some experts have recently questioned the importance of earnings estimates for share price movements, arguing the relationship between these two factors hasn’t been high over the past months, and has often been contradictory.

Certainly, it can hardly be denied the birth of a new bear market has pushed fundamental factors, such as earnings expectations, to the background, allowing fear, panic, financial deleveraging and a general loss of risk appetite to dominate the direction of share markets instead – that much is true. However, the suggestion that investors should not necessarily pay too much attention to earnings expectations is, in my view, only a strategy that suits the shorter term, momentum driven investor. For all other investors, earnings expectations may not be the key driver behind share prices right now, but ultimately they will decide which shares are genuinely cheap today, and which ones aren’t.

Assuming you are a longer term focused investor in the share market, current circumstances and information available are not exactly working in your favour – and that’s a grave understatement. It is not easy to do your homework these days in order to decide which stocks should be bought, and which ones should best be avoided. Securities analysts still have a ridiculous amount of Buy ratings outstanding for individual companies. Currently, still more than half of all recommendations issued by nine major stockbrokerages plus independent researcher Aspect Huntley consist of a Buy, or an equivalent of Buy. A little over 9% of all recommendations is Sell. (The latter is about as low as it gets in terms of the relative number of Sell ratings).

The problem is that at least half of these recommendations are based upon earnings expectations that are too high, and which will be lowered in the year ahead. The other half are purely valuation based, but are completely ignorant of the fact that overall sentiment does not favour particular sectors, or highly leveraged companies, or companies whose business model is now in question.

To a cynic, it can hardly be a surprise that earnings expectations are not the main driver behind share price movements at the moment, for the simple reason that nobody trusts them. However, as earnings expectations are being updated, new trends are being revealed and in combination with where share prices are at, this can provide investors with some valuable insights.

Take fund manager Perpetual Trustees ((PPT)), for example. The shares reached above $80 just prior to the term “subprime mortgages” hitting international headlines last year and they have gradually slipped, then fallen, to below $50 earlier in 2008 when general panic dominated local and international share markets. Since then the stock has recovered to $57-something. On this basis one would feel inclined to assume there should still be plenty of upside left for the shares. However, the trend in earnings expectations, in combination with price targets set by brokers, suggests this may be a dangerous assumption to make.

On current market expectations (which are still in a negative trend), Perpetual shares are trading at nearly 16 times projected earnings, both for this fiscal year as well as for next fiscal year. This already indicates the trend in overall expert expectations is that Perpetual will achieve no earnings growth this year and next year. This is partly correct. Revised expectations see Perpetual’s earnings decline both this year and next and any recovery thereafter will be largely dependent on the overall performance of financial markets throughout 2009 – and whether Perpetual can finally address the erosion of its client base.

The decline in overall expectations is reflected in a steady fall in price targets brokers have determined for the shares. What used to be labelled as a $80+ stock has gradually been replaced with price targets that start with a 7, then a 6, subsequently a 5 and one of the last brokers to update its views on the company, ABN Amro, has now set a price target starting with a 4. The average target for the stock has now fallen to $55.34, below the current share price.

This brings up an interesting dilemma: the shares are currently trading at an estimated dividend yield of 6.3%, and every time share markets rally the stock is at the forefront of that day’s market movers (as it is very much seen as a proxy for overall share market direction), but how much longer can Perpetual shares withstand the negative trend in earnings, in valuations and in price targets? And what are the chances for a swift reversal in fortune that will force brokers to start increasing their forecasts again?

Another example is Mortgage Choice ((MOC)). Similar to Perpetual Trustees, Mortgage Choice is currently caught in a negative spiral (as far as earnings prospects are concerned) as wholesale funding remains tough for mortgage companies and Australia’s major banks are starting to push for lower referral fees. According to the latest research updates on the company, the current trend of negative earnings growth could well continue into the next decade.

The main difference between Mortgage Choice and Perpetual Trustees is, however, that investors have largely abandoned the stock with the result that the current share price of below $1 is some 60% below the average target price. As a result, the shares carry a prospective dividend yield of more than 14%. But more so than in the case of Perpetual, valuations and forecasts for Mortgage Choice seem to have much further to fall still. As such, recent updated price targets by ABN Amro ($1.22) and UBS ($1.30) may prove to be more accurate than the ones set by Credit Suisse ($1.85) and others.

The irony is that if and when overall sentiment towards finance stocks, and mortgage companies in particular, will improve Mortage Choice is likely to offer much more upside potential than companies such as Perpetual Trustees because of the likely improvement in price-to-earnings ratio (PER). On current estimates (with a negative bias still) the shares are trading on a PER of less than 6.5 for the current year, and a little more than 6.5 for next fiscal year. But then again, what are the chances of the market lifting Mortgage Choice shares to a higher PER anytime soon?

In my view, Perpetual and Mortgage Choice currently represent the majority of stocks on the Australian Stock Exchange. One one hand there is a large group of companies that jumps and bounces very hard whenever the market experiences an upswing, but whose valuation multiples (and further upside potential) seem questionable at best. On the other hand, there’s an even larger group which is arguably trading at too low valuation multiples, but for which there is currently absolutely no appetite.

How do resources and energy stocks fit into this framework?

The likes of BHP Billiton ((BHP)), Rio Tinto ((RIO)), Newcrest Mining ((NCM)) and Woodside Petroleum ((WPL)) are currently trading at or near their highest valuation multiples since the start of the Super Cycle in late 2003. This obviously raises the question whether these stocks are not in a similar position as Perpetual Trustees (they are definitely not in the same group with Mortgage Choice).

One key factor that would seem to differentiate these companies is that there appears to be a genuine possibility of upside potential to current earnings estimates as most metals, and certainly crude oil and gas, have so far this year traded at much higher price levels for much longer than expected. This could imply that earnings estimates for the sector should be trending up later this year, which would make current share price levels automatically cheaper, but only if the positive momentum continues. This is likely to become the key question going into the second quarter of calendar 2008: how sustainable are current prices for gold, copper, aluminium, crude oil and steel?

Shorter term, the outlook for most commodities prices (and we include for convenience reasons precious metals as well) seems to be for another correction after having traded sideways for most of April thus far. The real question is, however, what will happen after this correction shall have run its course? Among the factors that can have a big impact on prices is a potential recovery for the US dollar (as investors have started to anticipate a much less aggressive Federal Reserve Bank from here on) but above all: will speculators continue to exit commodity markets?

The latter question seems more than appropriate as open interest data from the LME seem to suggest the so-called “hot money” has been retreating from commodity markets since late March. Given the substantial impact of speculative funds on these markets, this raises obvious questions about the extent and duration of the correction that lies ahead, especially with global economic growth to slow in the months ahead. All this will put the thesis of the Super Cycle to its first serious test.

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