Rudi On Thursday

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

(This story was originally published on Wednesday, 29th July, 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere.)

I used my presentation at the Australian Investors Association’s Conference in Surfers Paradise this week to emphasise that I believe the future holds many opportunities for investors in Australia. While I deliberately refrained from using bullish hyperbole, I did say, as I have done repeatedly over the past months, that I firmly believe the underlying trend for the share market, on a two-year outlook, is a positive one.

Apparently at least one speaker before me had suggested the share market was likely to pull back towards the end of the year.

And that was exactly the question I was asked whenever someone recognised me in the vicinity of the coffee table. Did I agree? Everything has a price, even in a bear market. What happens in the final weeks of the year will be partly determined by what happens with share prices between now and then. That’s not a cop out – that’s both a logical conclusion and a fact.

I don’t know how long the current return to risk embracement will last, or how far it will take prices of equities and other risky assets, but I do know that at some point prices become too expensive, and thus a retreat seems but the logical thing to expect.

The title of my presentation was “Opportunities in the Share Market?” and despite the question mark at the end (added at my explicit request a few months ago) you would have guessed already the answer would be a positive one. This might explain why the designated room of my presentation appeared full when I stepped up the podium after being introduced with a glowing commendation for the work we do here at FNArena.

I said I believed Australians don’t half realise how lucky they are with a share market that has put in the best performance among all markets over the past 150 years or so (not just my view but backed up by historical analysis by the likes of Credit Suisse) but above all, where listed companies elsewhere mostly pay low dividends (US) or no dividends at all (China), Australian companies on average pay high dividends – and the bear market sell-down has pushed share prices lower than dividends have been cut (or are expected to).

This means the present share market represents a clear dividend opportunity for investors with a longer term horizon. This remains true even after the strong rise seen since the second week of March.

First thing to keep in mind, of course, is that it is better to opt for companies that generate sufficient cash earnings to continue paying their shareholder dividends. Secondly, and I hereby return to my theme of the past months, it’s probably better to choose for companies that will grow in the years ahead, instead of going backwards or showing minor growth only.

After a downturn like the one we’ve seen since late 2007 you’d like to see companies bouncing back with some gusto, wouldn’t you? That way whatever we pay for their shares today, it’ll automatically become much cheaper in two (or more) years’ time.

The only tool we have at hand to do this is analyst expectations. Is this a 100% reliable tool? Ab-so-lu-te-ly not. I am prepared to take any bet that most forecasts today will be proved wrong in 24 months from now. But that doesn’t mean much. These forecasts shouldn’t be taken as an absolute given – they’re a measurement to take guidance from, nothing more and nothing less.

To put it in concrete terms: BHP Billiton’s ((BHP)) earnings per share are expected to grow by a little less than 40% in FY11. Will it matter whether reality will change this number into 45% or 35%? I don’t think so, not at this stage anyway. Many investors tend to lose sight of the fact that expectations move share prices, more so than actual announcements. By the time BHP releases its FY11 set of financial numbers it is likely that expectations regarding FY12 and FY13 will have already taken over.

Looked at it from a different viewpoint: the release of the actual results only matters in the way it impacts on expectations for the year(s) ahead.

That’s why I said on Monday: don’t spend too much time on what will happen in August. FY09 is all about what was in the past and the general media certainly will have a lot to write about: heavy reductions in profits, more write-downs, less dividends, more capital raisings. As long as it all falls in line with what analysts are expecting it won’t matter so much for share prices. August will likely bring us the worst results season in living memory – but there’s a difference from February: we’re prepared, possibly even over-prepared.

What this market (still lots of cash on the sidelines, don’t forget it) wants to find out is whether expectations for the next two years are anything to rely upon. Not in an absolute manner, but in the same way as I described above: with some sense of reliability which likely means a margin of error that falls in between “acceptible” and “historical average”.

We all know humans are fallible – we’ve just seen it day in, day out between late 2007 and early 2009. But can we more or less draw some guidance from what analysts have put in their reports for FY10 and FY11 – that’s what we, as a collective, would like to find out. The results season in August is going to assist us in this collective assessment.

One observation I have made over the past weeks I think deserves everyone’s attention: after many months of falling expectations (eight consecutive months I wrote recently) market expectations have started to rise again. This suggests that, if anything, current expectations are likely to rise further in the weeks ahead.

This might not only defy the eternal bears who believe analysts are being unrealistic with their projections for FY11, it might also fuel further advances for the share market. Under an extremely bullish scenario, the share market might well rise until all potential upside on the basis of FY11 projections has been priced in. Which brings me back to my answer during the refreshment breaks at the conference: whatever happens at a later stage is partly determined by what happens between now and then.

At what point will the market have reached full FY11 saturation, I hear you ask? Well, that depends on how high expectations will rise throughout August. After adding some 10% over the past two weeks, the Australian share market looks pretty expensive on FY09 numbers, fully priced on FY10 projections but still with plenty of upside left on FY11 numbers.

It’s always difficult to come up with a reliable source, but I’d estimate the average Price-Earnings ratio for the Australian share market is around 15x for FY09 (historical average is about 15x), around the same number for FY10 (depending on to whom you believe FY10 is to bring further losses or small profit gains) and at around 11x for FY11 projections. Applying a very simple method would be to put FY11 PERs at 15x – this means a multiple of four extra points on higher profits - that’s still plenty of upside. More than plenty, in fact.

Here are a few numbers I plucked from recent analysis during the presentation on Monday:

– BHP Billiton is expected to improve its earnings per share (EPS) by some 40% in FY11 compared with FY10
– Rio Tinto ((RIO)), however, is only expected to grow its EPS by mid-teens in each of the next two years
– ANZ bank ((ANZ)) is expected to grow its EPS by 32% in FY11
– Commbank ((CBA)) is forecast to grow EPS by 34% in FY11

A few facts regarding the above mentioned dividends:

– At $31, BHP Billiton shares provide an estimated 4% FY10 dividend yield – this is equal to the long term running average for the Australian share market
– At $32.50, BHP Billiton shares provide an estimated 4% FY11 dividend yield
– Currently trading above $37, BHP shares still provide around 3.5% dividend yield on FY11 forecasts
– Telstra is currently yielding in excess of 9% on FY11 estimates
– At a little above $22, National Australia Bank ((NAB)) is yielding close to 7.5% on FY11 projections
– BlueScope Steel ((BSL)) yields in excess of 5% if current projections for FY11 prove to be true
– Oz Minerals ((OZL)) carries a potential FY11 yield of 4.5%
– AMP ((AMP)) shares currently carry a FY11 yield of 6.5%

What many investors don’t realise is that “dividend yield” is not a static fact – when combined with robust growth, dividend yields can become very attractive when shares are held in porfolio for the longer term.

ANZ Bank, for instance, is widely expected to reduce its FY10 dividend payout which would lead to a drop in dividend yield for each share to 5.4%, but given the strong growth projected for FY11 the yield is projected to jump to 6.8%. If we assume 10% growth for each of the following two years the yield would  jump further to near 7.5% in FY13 and to 8.2% in FY14. It doesn’t take too much imagination to see what will happen in the following years assuming ANZ Bank continues to grow.

This is what a cheaper than the historic average share price valuation in combination with the resumption of growth in the future can do to today’s investment metrics. All you have to do as a longer term investor is buy in at today’s prices and hold on to the shares.

Also, there is one very important side-effect to picking good dividend yielding stocks: in case current predictions of a long and drawn out economic recovery prove correct, and share markets respond by not generating too much of an exciting return (on a net basis) over the years ahead, you will still have your returns in dividends.

The key factor behind everything I said so far is “growth”. We can dispute whether BHP Billiton really will manage to grow its profits for shareholders by 40% in FY11, or whether it will prove to be a more modest 25%, for some companies, or even whole sectors, current expectations are that growth overall will be tough to achieve, and it will likely come in single digits only under best case scenarios.

Sectors that are presently suffering from low market expectations are property related stocks – most listed trusts but also the likes of Mirvac ((MGR)) and Westfield ((WDC)); engineering and industrial service providers -such as Leighton ((LEI)) and Monadelphous ((MND)); gaming and gambling stocks (Tabcorp ((TAH)) and Tatts ((TTS)) among others) as well as media companies such as Fairfax ((FXJ)) and West Australian News ((WAN)).

Little or no growth is currently assumed for companies such as Computershare ((CPU)), QBE ((QBE)), Fleetwood Corp ((FWD)), Hills Industries ((HIL)), Bradken ((BKN)) and Brambles ((BXB)).

Regardless of what your risk profile or investment horizon is, robust growth should beat the absence of growth, even if some of the latter companies look relatively cheaply priced in the present market. Sometimes “cheaper” doesn’t mean “cheap” at all.

With these thoughts I leave you all this week,

Till next week!

Your editor,

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

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