Rudi On Thursday – Special Edition

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

This story was originally published on Thursday September 18 but was only made available to paying subscribers at the time. It has now been re-published.

At least one retail broker has sent out a report this morning that appears to have but one aim: convincing investors this week’s sell-off has opened up value opportunities in the Australian share market.

As I stated in my editorial late yesterday (see Rudi On Thursday, September 17): at major inflection points securities analysts always find themselves at the tail end of the curve, and this time is certainly no different. As far as the brokers who sent out these reports are concerned: trying to blame them is a bit churlish. It’s what they do for a living. The information in the report is all they have to work with.

That’s why I argued yesterday investors should always throw in their own judgement, knowledge and insight. It’s your money.

There are two major problems in trying to assess whether there’s true and genuine value in the share market at current beaten down levels. One is the overall outlook is clearly still deteriorating, both from a financial and from an economic point of view. Secondly, securities analysts still hadn’t gone far enough in lowering their forecasts. This is not something I just made up myself, various market strategists at local and international stockbrokerages have been expressing the same view over the past weeks.

Current consensus forecast is for average EPS growth of 7-8% in Australia this financial year. Arguably, and given the two main factors I mention above, it’s probably safer to take 0% growth as a basis assumption and start adjusting from there. Strategists at GSJB Were this morning argue they believe 0-3% EPS growth would seem like a more realistic outlook for Australian companies in the year ahead. I won’t argue with that.

Some commentators will be pointing out that on a forward looking PE (price/earnings) basis, the Australian share market is now close to levels not seen since about twelve years. While that may be true, and it is bound to be repeated in newspapers, on television, and in various research reports, it only tells you half of the story. Once those forward looking expectations are being pulled closer to reality, the market’s PE number will instantly correct itself to a more realistic level.

Investors should always bear in mind that lower earnings forecasts automatically push up price-earnings ratios without the need for share prices to rise too.

The most obvious mistake investors can make when trying to locate trading or longer term value opportunities, is to look at where share prices have been and draw any sorts of conclusion from this. Don’t. This is the classic rear view mirror mistake Warren Buffett talks about when he says investors tend to assess which way is forward by looking at their rear view mirror.

Think about how shares of Babcock and Brown ((BNB)) fell from $31-plus to around $8. Surely, if one would have looked in his rear view mirror this would have seemed like the greatest bargain in town. Until the shares halved again to $4. Surely… Last time I looked the shares were trading at around 72c.

In hindsight, buying Babcock and Brown shares at any stage between $8 and 72c looks incredibly stupid. However, I did speak to a professional investor recently who said he had been attending various trading courses and investment seminars over the past weeks, to put his feelers out about what was happening in the world of retail investors. Guess what most of them had been doing?

They had been buying Babcock and Brown shares at “bargain” prices between $8 and $2.

What goes for Babcock and Brown goes for all other stocks in the market, be they BHP Billiton ((BHP)), Commonwealth Bank of Australia ((CBA)) or Wesfarmers ((WES)). And it goes for the market as a whole as well.

As such, say strategists at GSJBW, this week’s panic driven sell-down is opening up great opportunities for investors with a longer term view. Again, while this is undoubtedly true, it still seems best to tread gently and to think about “avoiding mistakes” above anything else. Even GSJBW strategists advise their clientele “to selectively increase their exposure” to any stocks at times like these.

For what it’s worth, the strategists reiterate their view it’s best to look for big companies with strong franchises and strong and healthy balance sheets (I bet you’ve heard that before in the months past). Among consumer staples stocks the stockbroker likes Woolworths ((WOW)), Foster’s ((FGL)), Coca-Cola Amatil ((CCL)), and Wesfarmers ((WES)). In the telecom industry only Telstra ((TLS)) is worth considering, say the strategists, while Cochlear ((COH)) and Healthscope ((HSP)) are preferred in the healthcare sector.

The wider group of “Industrials” generates four preferred candidates: Austar ((AUN)), Brambles ((BXB)), Toll Holdings ((TOL)) and News Corp ((NWS)). Domestic Cyclicals only generate two names: Boral ((BLD)) and OneSteel ((OST)).

This leaves us with two more groups: financials and resources. Post this week’s events in the US, most strategists seem convinced tough times are here to stay for financials and thus they wouldn’t advise jumping on any apparent bargains in the sector at this stage. ABN Amro banking analysts published a report on the sector today (the second this week) and they reiterated their negative view, essentially advocating investors stay away from the sector until things have cleared up.

GSJBW is singing to the same tune as ABN Amro, suggesting investors may want to wait until market updates in February that may provide them with more clarity about what’s happening in the global and local banking world.

And resources? That is one big hot potato in the current context. Various market strategists are advising their clientele to stay away as long as the economic outlook remains on a downward slope. GSJBW, however, is part of the supercycle club and believes investors should remain faithful to the stronger for longer theme. Look for bulk commodities, copper, and mining services, the strategists say.

What we are going to see, any moment now, is for share markets to stop falling and possibly stage a rally. This is simply how things go after days of significant selling-pressure. The same thing happened in March this year. Before that the same happened after the initial subprime-Bear Stearns scare in August 2007. Look, for instance, at how crude oil has behaved since its steep fall from US$100-plus to near US$90 (intra-day). (It’s back at US$97 in one go today).

The jury is still out whether any such rally will prove to be sustainable. Some commentators have flagged the possibility of a rally sometime between the end of October and February. Others believe we are more likely to only see more of what we’ve seen in the two months prior to September: high volatility in a market essentially going nowhere.

What is interesting to note is that, so far, the scenario that is unfolding is almost exactly as suggested by the institutional team at GSJB Were four weeks ago. I described this scenario in my Rudi On Thursday editorial on 27 August (We kept it for paying subscribers only at the time). Just to recap: the team said that in any year US shares were down by at least 12% by the end of August, September had proved to be an absolute shocker generating additional losses to the tune of 9% for the month alone in 11 out of 14 previous occasions since 1900.

So far, this week has brought losses for US shares in the order of 7.6%, taking the total loss for this month to 9.8% (S&P500).

A few weeks ago such a scenario looked pretty unbelievable, but here we are in the third week of September and the numbers speak for themselves.

If history is any guide, the remainder of the year should bring more losses for US shares, reports the same institutional desk. (Offsetting this is the fact that, on the institutional desk’s calculations, the Australian share market has now suffered for longer and more deeply than has traditionally been the case in past bear markets).

After shedding close to 30% since the November peak last year, have we now finally landed in “cheap” territory or not?

It all depends on those two major forces I cited at the beginning of this story: falling economic growth (with the extra flavour this time around of deteriorating circumstances for financial institutions) and securities analyst’s forecasts. Both factors are obviously closely linked to each other. The timing and magnitude for both remains uncertain at this stage, but their outcome will ultimately determine whether this market has finally seen the worst, and when.

Market strategist Adnan Kucukalic and his team at Credit Suisse is not yet convinced. In an update today, Kucukalic predicts a bounce is forthcoming, but he doesn’t believe it will be the real thing just yet. While acknowledging value is starting to appear in the Australian share market, Kucukalic also believes investors should bear in mind that, on a medium term basis, 15-20% more downside is a real possibility, he says.

Part of this expectation appears premised on the assumption that global economic growth is likely to weaken further in the months ahead; and we all know that bad news brings out more bad news. As such, this is likely to deliver another blow to overall investor confidence, suggests the CS strategist, which explains why he believes the potential for “overshooting to the downside” cannot be completely dismissed.

To keep the public discussion alive about whether investors should include resources companies in their near term strategy or not: Kucukalic believes that were another sell-down to follow in the months ahead the next one is likely to centre around resources companies. His prediction is based on the premise that slower economic growth translates into lower demand for commodities. The rest, I am sure, you can all fill in yourself.

Kucukalic too implicitly questions the eagerness with which some market commentators are calling for lots of obvious value in a beaten down share market. Whether there’s value or not in certain sectors and in certain stocks on a medium term basis will be determined by how much further economies will slow and by how much consensus earnings forecasts will fall in the months ahead.

And that’s where investors have to use their own insight and knowledge. Always remember, it’s your money.

(This Special Edition is best digested in conjunction with my regular Rudi On Thursday editorial from September 17).

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by Greg, Andrew, Joyce, Todd, Grahame, George, Pat and Chris)

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