Rudi On Thursday

This story features WESTPAC BANKING CORPORATION, and other companies. For more info SHARE ANALYSIS: WBC

Banking stocks, and most other financials, retreated on Wednesday. This was reportedly because investors became a little worried again that problems in global credit and debt markets may not be over soon, as some had started to hope for.

For all we know this may have been the reason for the pullback. But then again, there may have been other factors in play as well.

On Tuesday I had another look at the various banks in FNArena’s Stock Analysis section. I noticed that some banking stocks had appreciated within a relatively short distance of their average price target. One of them, Westpac ((WBC)), widely considered the best in the sector to own this time around, had even risen above its average price target.

Considering that the average target for Westpac is receiving extra support from an overenthusiastic team of banking analysts at Merrill Lynch (they have a target of $29), I wondered how long it would take before the shares would start to retreat.

Those readers who have been reading my weekly musings for a while now know I am a true believer in average price targets, especially in the case of relatively steady earnings forecasts such as is usually the case for banks. It can be a different thing altogether for commodity producers and energy companies, as prices for their products can record huge swings, but for a sector such as the Australian banks average price targets are usually a reliable indicator.

As everyone who has been reading our news stories on the sector recently would have picked up, Westpac is the most expensively priced among its peers as it is widely regarded the best investment option in the sector. No wonder thus that Westpac shares were the only ones that managed to surge above their average target, while others still had some extra space left.

However, the question that sprang to mind yesterday was: can other banks rise further when Westpac effectively is pushing beyond value limits?

To draw a parallel with the recent past: prior to the global share market correction in January, CommBank ((CBA)) was the leader of the pack in Australia, always a tad more expensively priced than the others. And when CommBank shares surged beyond their average price target of around $60 towards the end of last year, I could hear alarm bells ringing.

We all know what followed next.

Until January I used to see Australian banks as a proxy for the market as a whole. I therefore had no problems in expressing myself in a cautionary manner about the share market’s outlook at the time.

Since then, however, a few things have changed. CommBank is no longer the leader of the pack, that role is now firmly in the hands of Westpac. But are banks still a proxy for the market in general?

Interesting question.

One of our regular guest contributors, Charlie Chartchecker, believes the answer to this question remains affirmative. Independent from my personal analysis, Charlie sent us several charts with explanation on Tuesday. In essence, Charlie agrees with what his peer the TechWizard had already expressed: this market seems poised for another “correction”.

Forget about technical charts and indicators for a moment, there is a very straightforward reason why share markets have risen recently: as overall sentiment turned towards a view that the worst now appeared behind us, investors started to look at undervalued shares and they started buying.

Banks, we all know, appeared cheap so it is no wonder they have been among the biggest beneficiaries of the early recovery. Importantly, though, this recovery was purely valuation driven. There’s no improvement on the immediate horizon. There may be some hope, but there was –above anything else- a cheap proposition on offer and if, investors reasoned, if things won’t turn out as badly as initially feared, then maybe banking stocks don’t need to be as cheap as they are?

This is why shares went up while earnings estimates are still falling. However, the second part of the previous sentence now raises an interesting question: can Westpac rise beyond its targets while earnings estimates are trending down? (The latter means there is in itself little reason to assume these targets will rise in the short term).

I note, after the market’s close on Wednesday, that Westpac shares are now back below their average price target, but the distance is not huge. Projected price/earnings ratio is 12.4 with an estimated dividend yield of 5.7%. The bulls will argue this is still below historical values. I happily counter that current market projections foresee EPS growth of some 8% this fiscal year and circa 4.5% in fiscal 2009. Those two figures are not only revealing a declining trend, they are below historical trend as well.

As a comparison: Westpac’s EPS improved by nearly 13% last year.

Personally, I am not so sure whether the banks still act as a proxy for the broader market, as they have their own specific sets of problems and everyone is now aware of this, but I would argue that Westpac, the current leader in the sector, is pushing value limits now. This will restrict any further upside for the sector as things stand right now.

(Unless someone can provide me with a genuine reason why banks should trend back towards their previous valuation multiples in the short term, of course. But I fail to see how anyone can.)

Assuming the banks are no longer a proxy for the wider market, does this mean the leadership role has now shifted towards resources and energy companies?

Here too I notice (same Stock Analysis feature on our website) many leading resources companies are either approaching average price targets (such as BHP Billiton ((BHP)) and Rio Tinto ((RIO)) or trading above targets (energy companies such as Woodside ((WPL)) and Santos ((STO)).

The difference between these companies and the banks, however, is that banks are in a downward trend as far as earnings expectations and price targets are concerned, while the trend for BHP et al is still for further improvements on most accounts. The reason is as simple as anyone could think of: prices for oil, copper and steel are persistently higher than anyone would have predicted at the start of the new year.

This has opened up a whole new public debate: are current prices based on fundamental factors or are they mainly caused by investors and speculators playing around with our perception?

Answer this question correctly and you probably have an answer to the question whether this market has further upside potential left for the medium term, or not.

Given that problems in the financial sector are unlikely to simply melt away in the foreseeable future, and that banking stocks have given up their ultra cheap label, I think there is a strong argument in favour of the thesis that resources and energy stocks are the Australian share market’s new leaders.

The reward for this change in leadership has come in the form of PE ratios that have never been this high in the current cycle. Oxiana ((OXR)), for instance, is currently trading at near 20 times this year’s projected EPS (subject to further increases, I’d add to that).

BHP is trading at a PER of nearly 16.5. Woodside sits above 20. Newcrest Mining ((NCM)) is at 25.

Those in favour of the sector will put forward that all these calculations are based upon product prices that are significantly below today’s prices for oil, gas, copper and other materials. And they are correct. So all mentioned PERs for resources and energy producers will fall to par with the banks if and when securities analysts start updating their earnings models.

The longer current prices will be sustained, the higher the impact in the second half of 2008 and into 2009. All this comes with the caveat, of course, we won’t see a sudden collapse at some stage (which some marketwatchers believe remains a genuine possibility).

At the top of the market, as far as valuation multiples go, are engineering and mining services companies. With exceptions such as Emeco ((EHL)) and Industrea ((IDL)), most of these companies are trading at multiples above the rest of the market, and some significantly above 20. WorleyParsons ((WOR)), for instance, currently has a PER of more than 27 for this year and around 23 for 2009.

Leighton Holdings ((LEI)) is trading at 21.5 and 18 respectively; Transfield Services ((TSE)) at 22.5 and 18. These companies have no direct exposure to wildly fluctuating product prices; they are merely dependent on their customers remaining highly profitable (and positively minded).

What does the future hold for these companies?

Analysts at UBS asked themselves the same question. They sought answers via an in-depth study. The result is an expected average profit jump of some 26% this fiscal year (for the sector) and some 10% for each of the following three years. UBS acknowledges the sector is trading at a considerable premium to the rest of the market. This would suggest some caution is warranted, despite the above average outlook.

(Always keep in mind that an attractive stock has two key features: projected earnings growth and present valuation).

UBS thinks investors can still safely jump on board WorleyParsons, Orica ((ORI)), NRW Holdings ((NWH)) and Transfield Services ((TSE)).

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Time to finish off with a special announcement: your editor has been invited to make his television debut on Sky Business. As such I will be joining two other journalists for an hour long commentary on financial matters this Saturday from 9 to 10am on a program called Business View.

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Till next week!

Your editor,

Rudi Filapek-Vandyck

(as always firmly supported by the Fabulous Team of Greg, Grahame, Joyce, Chris, Pat, George, Paula and Sarah)

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